Who Limits Arbitrage?

48 Pages Posted: 18 Apr 2019 Last revised: 1 May 2021

See all articles by Nathan Foley-Fisher

Nathan Foley-Fisher

Board of Governors of the Federal Reserve System

Borghan Narajabad

Board of Governors of the Federal Reserve System

Stephane Verani

Board of Governors of the Federal Reserve System

Date Written: April 30, 2021

Abstract

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

Foley-Fisher, Nathan and Narajabad, Borghan and Verani, Stephane, Who Limits Arbitrage? (April 30, 2021). Available at SSRN: https://ssrn.com/abstract=3361902 or http://dx.doi.org/10.2139/ssrn.3361902

Nathan Foley-Fisher (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Borghan Narajabad

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Stephane Verani

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

HOME PAGE: http://www.federalreserve.gov/econresdata/stephane-verani.htm

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