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Financial Relationships and the Limits to Arbitrage

Author

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  • Jiro E. Kondo
  • Dimitris Papanikolaou

Abstract

We propose a model of limited arbitrage based on financial relationships. Financially constrained arbitrageurs may choose to seek additional financing from banks that have the technology to profit from the strategies themselves. A holdup problem arises because banks cannot commit to providing capital. To minimize competition, arbitrageurs will choose to stay constrained and underinvest in the arbitrage unless banks have sufficient reputational capital. This problem arises when mispricing is largest. More competition among financiers, higher arbitrageur wealth, and allowing for explicit contracts can worsen the holdup problem. When arbitrage is risky, financial relationships are more valuable, mitigating the problem.

Suggested Citation

  • Jiro E. Kondo & Dimitris Papanikolaou, 2015. "Financial Relationships and the Limits to Arbitrage," Review of Finance, European Finance Association, vol. 19(6), pages 2095-2138.
    • Handle: RePEc:oup:revfin:v:19:y:2015:i:6:p:2095-2138.
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    File URL: http://hdl.handle.net/10.1093/rof/rfu051
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    References listed on IDEAS

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    Cited by:

    1. Piccotti, Louis R., 2020. "Strategic trade when securitized portfolio values are unknown," Journal of Banking & Finance, Elsevier, vol. 115(C).
    2. Jingzhi Chen & Charlie X. Cai & Robert Faff & Yongcheol Shin, 2022. "Nonlinear limits to arbitrage," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(6), pages 1084-1113, June.
    3. Jiro Kondo & Danielle Li & Dimitris Papanikolaou, 2021. "Trust, Collaboration, and Economic Growth," Management Science, INFORMS, vol. 67(3), pages 1825-1850, March.
    4. Dimitris Papanikolaou, 2015. "Cooperation Cycles: A theory of endogenous investment shocks," 2015 Meeting Papers 71, Society for Economic Dynamics.

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