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Asset Pricing with Arbitrage Activity

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  • Julien Hugonnier

    (Swiss Federal Institute of Technology Lausanne, Ecole Polytechnique Fédérale de Lausanne, and Swiss Finance Institute)

  • Rodolfo Prieto

    (Boston University)

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.

Suggested Citation

  • Julien Hugonnier & Rodolfo Prieto, 2013. "Asset Pricing with Arbitrage Activity," Swiss Finance Institute Research Paper Series 13-57, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1357
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    More about this item

    Keywords

    Limits of arbitrage; Rational bubbles; Wealth constraints; Excess volatility; Leverage effect;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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