Equilibrium and welfare in markets with financially constrained arbitrageurs

Abstract

We propose a multi-period model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets, traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. In our model, arbitrage activity benefits all investors because arbitrageurs supply liquidity to the market. However, arbitrageurs may fail to take a socially optimal level of risk, in the sense that a change in their positions may make all investors better off. We characterize conditions under which arbitrageurs take too much or too little risk.