Capital Market Equilibrium with Mispricing and Arbitrage Activity

Rodney L. White Center for Financial Research Working Paper Series 6-98

Posted: 29 Apr 1998

See all articles by Benjamin Croitoru

Benjamin Croitoru

McGill University - Desautels Faculty of Management

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Abstract

This paper develops a general equilibrium, continuous time model where portfolio constraints generate mispricing between redundant securities. Constrained consumption-portfolio optimization techniques are adapted to incorporate redundant, possibly mispriced, securities. We demonstrate the necessity of mispricing for equilibrium when agents are heterogeneous enough. The construction of a representative agent with stochastic weights allows us to characterize prices and allocations, given mispricing occurs, in a general setting. Under logarithmic preferences, we provide explicit conditions for mispricing and closed-form expressions for all economic quantities. Existence of an equilibrium when mispricing occurs with positive probability is verified in a specific case. We demonstrate how mispricing induces agents to engage in riskless arbitrage trades.

JEL Classification: C60, D52, D90, G12

Suggested Citation

Croitoru, Benjamin and Basak, Suleyman, Capital Market Equilibrium with Mispricing and Arbitrage Activity. Rodney L. White Center for Financial Research Working Paper Series 6-98. Available at SSRN: https://ssrn.com/abstract=81329

Benjamin Croitoru

McGill University - Desautels Faculty of Management ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
514-398-3237 (Phone)
514-398-3876 (Fax)

Suleyman Basak (Contact Author)

London Business School ( email )

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London, London NW1 4SA
United Kingdom
44 (0)20 7000 8256 (Phone)
44 (0)20 7000 8201 (Fax)

HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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