Working Paper: NBER ID: w15821
Authors: Denis Gromb; Dimitri Vayanos
Abstract: We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.
Keywords: limits of arbitrage; market anomalies; financial institutions; agency frictions; asset pricing
JEL Codes: D6; D8; G1; G2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Demand shocks (E39) | Mispricings in asset markets (G19) |
| Costs faced by arbitrageurs (G19) | Mispricings in asset markets (G19) |
| Demand shocks (E39) | Pricing of assets (G19) |
| Costs faced by arbitrageurs (G19) | Pricing of assets (G19) |
| Demand shocks (E39) | Amplification of costs faced by arbitrageurs (G19) |
| Costs faced by arbitrageurs (G19) | Deviations from the law of one price (F31) |
| Institutional frictions and agency issues (D23) | Inability of arbitrageurs to correct mispricings (D52) |