Who Limits Arbitrage?
48 Pages Posted: 18 Apr 2019 Last revised: 1 May 2021
Date Written: April 30, 2021
Limits of arbitrage prevent prices from fully revealing securities' fundamental value. We show that risk taking in the securities lending market, which operates in tandem with the spot market, plays an important role in shaping the limits of arbitrage. Securities lenders taking greater risk with their cash collateral reinvestment decrease short-selling costs and increase price informativeness in the securities spot market. We identify this causal relationship in a data set matching corporate bond loans and trades to securities lenders' cash collateral reinvestment. The effect of risk taking by securities lenders is large, narrowing the bid-ask spread by around ten basis points.
Keywords: limits of arbitrage, securities lending, corporate bonds, market
JEL Classification: G11, G22, G23
Suggested Citation: Suggested Citation