Working Paper: CEPR ID: DP3049
Authors: Denis Gromb; Dimitri Vayanos
Abstract: We propose a multi-period model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets, traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. We derive an equilibrium and study its welfare properties. Allowing arbitrageurs to trade makes all investors better off. Arbitrageurs' positions may not be Pareto optimal, however, in the sense that a change in these positions may make all investors better off. We characterize conditions under which arbitrageurs take excessive or too little risk.
Keywords: arbitrage; borrowing constraints; collateral; liquidity; welfare
JEL Codes: D62; G12; G18; G23; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Collateral constraints (D10) | Arbitrageurs' positions in risky assets (G19) |
| Arbitrageurs' trading (G19) | Market welfare (D69) |
| Financial constraints (D10) | Risk-taking behaviors (D91) |
| Risk-taking behaviors (D91) | Market stability and welfare (D53) |
| Wealth levels (D31) | Arbitrageurs' positions in risky assets (G19) |