Asset pricing with arbitrage activity

Julien Hugonnier and Rodolfo Prieto

Journal of Financial Economics, 2015, vol. 115, issue 2, 411-428

Abstract: We study an economy populated by three groups of myopic agents: constrained agents subject to a portfolio constraint that limits their risk taking, unconstrained agents subject to a standard nonnegative wealth constraint, and arbitrageurs with access to a credit facility. Such credit is valuable as it allows arbitrageurs to exploit the limited arbitrage opportunities that emerge endogenously in reaction to the demand imbalance generated by the portfolio constraint. The model is solved in closed-form, and we show that, in contrast to existing models with frictions and logarithmic agents, arbitrage activity has an impact on the price level and generates both excess volatility and the leverage effect. We show that these results are due to the fact that arbitrageurs amplify fundamental shocks by levering up in good times and deleveraging in bad times.

Keywords: Limits of arbitrage; Rational bubbles; Wealth constraints; Excess volatility; Leverage effect (search for similar items in EconPapers)
JEL-codes: D51 D52 G11 G12 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Working Paper: Asset Pricing with Arbitrage Activity (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:115:y:2015:i:2:p:411-428

DOI: 10.1016/j.jfineco.2014.10.001

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