Who Limits Arbitrage?
35 Pages Posted: 18 Apr 2019
Date Written: March 22, 2019
This paper proposes and tests a theory of endogenous limits of arbitrage. We incorporate short-sale restrictions and an imperfectly competitive securities lending market into a model of securities traders with private information. The cost of short selling a security is an equilibrium outcome of the demand for short positions and the willingness of buy-and-hold institutional investors to supply their securities to short sellers. Securities lenders with greater risk tolerance are more willing to lend their securities, lowering the cost of taking short positions, which increases price informativeness in the spot trading market. We provide compelling evidence that the corporate bonds held by more risk tolerant insurance companies with securities lending programs tend to have greater spot market trade volume and more price informativeness. Controlling for each individual bond's demand, we identify the mechanism proposed by the model. Insurance companies with more risky cash collateral reinvestment portfolios are more willing to lend corporate bonds that are otherwise costly for short sellers to borrow. Our results suggest a new connection between liability-driven investment and asset pricing.
Keywords: limits of arbitrage, securities lending, life insurers, corporate bonds, market
JEL Classification: G11, G22, G23
Suggested Citation: Suggested Citation