Limited Arbitrage, Segmentation, and Investor Heterogeneity: Why the Law of One Price So Often Fails

Sean Flynn

No 56, Vassar College Department of Economics Working Paper Series from Vassar College Department of Economics

Abstract: There are numerous examples of assets with identical payout streams being priced differently. These violations of the law of one price result from two factors. First, investors have heterogeneous asset valuations so that if two groups of investors trade in segmented markets they are likely to set different prices because they have different expectations as to the value of the identical assets. Second, such discrepancies can only persist if arbitrage activities are limited. There appear to be two major limitations, short sales constraints and noise trader risk. Those assets facing short sales constraints have an asymmetric distribution of pricing violations because short sales constraints only bind when asset prices are too high. By contrast, assets facing noise trader risk have symmetric violation distributions because noise trader risk must be born by arbitrageurs both when prices are too low as well as too high.

Date: 2003-11
New Economics Papers: this item is included in nep-fmk and nep-ifn
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