DP3049 Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs

Author(s): Denis Gromb, Dimitri Vayanos
Publication Date: November 2001
Keyword(s): arbitrage, borrowing constraints, collateral, liquidity, welfare
JEL(s): D62, G12, G18, G23, G30
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3049

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. We derive an equilibrium and study its welfare properties. Allowing arbitrageurs to trade makes all investors better off. Arbitrageurs' positions may not be Pareto optimal, however, in the sense that a change in these positions may make all investors better off. We characterize conditions under which arbitrageurs take excessive or too little risk.