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Limits of Arbitrage

Author

Listed:
  • Denis Gromb
  • Dimitri Vayanos

    (INSEAD, Fontainebleau, 77305, France
    Center for Economic and Policy Research (CEPR), London EC1V 0DG, United Kingdom
    London School of Economics, London WC2A 2AE, United Kingdom
    National Bureau of Economic Research (NBER), Cambridge, Massachusetts 02138)

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: (a) risk, both fundamental and nonfundamental; (b) short-selling costs; (c) leverage and margin constraints; and (d) constraints on equity capital. We finally discuss implications for welfare and policy and suggest directions for future research.

Suggested Citation

  • Denis Gromb & Dimitri Vayanos, 2010. "Limits of Arbitrage," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 251-275, December.
    • Handle: RePEc:anr:refeco:v:2:y:2010:p:251-275
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    File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-financial-073009-104107
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    More about this item

    Keywords

    market anomalies; liquidity; financial constraints; financial institutions;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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