Arbitrage with Inelastic Liquidity Demand and Financial Constraints

This paper derives arbitrage trading strategies taking into account the fact that the actions of arbitrageurs impact prices. This avoids the difficulty of having to rely on exogenous position limits to prevent infinite arbitrage profits. When arbitrageurs are financially constrained their trading strategies can be expressed as feedback functions of their capital, which in turn depends on the optimal amount traded. An important component of the trading by financially constrained arbitrageurs is done to guarantee future financial flexibility. It is this hedging component that explains why price deviations persist in spite of arbitrage. Financial constraints are also responsible for periods of excessively volatile prices and for the time variation in the correlation of price deviation across markets. The fact that the actions of regulated firms can influence the dynamics of prices on which minimum capital requirements are based raises important implications for the regulation of securities firms.