Limits of Arbitrage: The State of the Theory

Denis Gromb and Dimitri Vayanos

No 15821, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

JEL-codes: D6 D8 G1 G2 (search for similar items in EconPapers)
Date: 2010-03
Note: AP
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Citations: View citations in EconPapers (168)

Published as Limits of Arbitrage: The State of the Theory, Annual Review of Financial Economics, 2010, 2, 251-275. (With Denis Gromb)

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Related works:
Working Paper: Limits of Arbitrage: The State of the Theory (2010)
Working Paper: Limits of arbitrage: the state of the theory (2010)
Working Paper: Limits of Arbitrage: The State of the Theory (2010)
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