Abstract

In a world were trading is costless, assets with identical cash flows must have identical prices. If arbitrageurs face unit time costs, or holding costs, the prices of these assets need not be equal, i.e the assets can be relatively mispriced. This paper constructs a dynamic model of the equilibrium determination of prices under costly arbitrage. Our analysis reveals that:

(i) Mispricing and arbitrage can exist in a market equilibrium.

(ii) Riskless arbitrage arguments may not provide tight bounds around observed market prices.

(iii) Arbitrage activity reduces equilibrium mispricing and is particularly effective when liquidity shocks are transient and conditionally volatile.

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http://bikibook.com/books/holding-costs-and-equilibrium-of-arbitrage/


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