Asset Pricing with Arbitrage Activity

Julien Hugonnier and Rodolfo Prieto
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Rodolfo Prieto: Boston University

No 13-57, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: WWe study an economy populated by three groups of logarithmic 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 uncollateralized credit. Such credit is valuable as it allows arbitrageurs to exploit the limited arbitrage opportunities that emerge endogenously in reaction to the portfolio imbalance generated by constrained agents. The model is solved in closed-form and we show that, in contrast to most equilibrium 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 lever up in good times and delever in bad times, and also investigate the effects of an unexpected tightening of the funding liquidity conditions of arbitrageurs.

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)
Pages: 56 pages
Date: 2013-11
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Related works:
Journal Article: Asset pricing with arbitrage activity (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1357

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