Arbitrage with Holding Costs: A Utility-Based Approach

Bruce Tuckman and Jean-Luc Vila

Journal of Finance, 1992, vol. 47, issue 4, 1283-302

Abstract: Unit time costs, or holding costs, are incurred in many arbitrage contexts. Examples include losing the use of short sale proceeds and lending funds at below market rates in reverse repurchase agreements. This paper analyzes the investment problem of a risk-averse arbitrageur who faces holding costs. The model allows prices to deviate from "fundamental" values without allowing for riskless arbitrage opportunities. After characterizing an arbitrageur's optimal strategy, the model is examined in the context of the Treasury market. The analysis reveals that holding costs are an important friction in this market and that they can significantly affect arbitrageur behavior. Copyright 1992 by American Finance Association.

Date: 1992
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