Financial Relationships and the Limits to Arbitrage

43 Pages Posted: 26 Jul 2005

See all articles by Jiro E. Kondo

Jiro E. Kondo

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Dimitris Papanikolaou

Northwestern University - Kellogg School of Management - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: June 2005

Abstract

We propose a new foundation for the limits to arbitrage based on financial relationships between arbitrageurs and banks. Financially constrained arbitrageurs may choose to seek additional financing from banks who can understand their strategies. However, a hold-up problem arises because banks cannot commit to provide capital and have the financial technology to profit from the strategies themselves. Weary of this, arbitrageurs will choose to stay constrained and limit their correction of mispricing unless banks have sufficient reputational capital. This form of limited arbitrage arises when mispricing is largest and becomes more substantial as the degree of competition between banks intensifies and arbitrageur wealth increases.

Keywords: Limits to arbitrage, inefficient markets, financial relationships

Suggested Citation

Kondo, Jiro E. and Papanikolaou, Dimitris, Financial Relationships and the Limits to Arbitrage (June 2005). Available at SSRN: https://ssrn.com/abstract=759984 or http://dx.doi.org/10.2139/ssrn.759984

Jiro E. Kondo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

50 Memorial Drive, E52-416
Cambridge, MA 02142
United States
617-324-6709 (Phone)
617-258-6855 (Fax)

HOME PAGE: http://web.mit.edu/jekondo/www

Dimitris Papanikolaou

Northwestern University - Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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