Financial Relationships and the Limits to Arbitrage

Jiro E. Kondo*, Dimitris Papanikolaou

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

4 Scopus citations

Abstract

We propose a model of limited arbitrage based on financial relationships. Financially constrained arbitrageurs may choose to seek additional financing from banks that have the technology to profit from the strategies themselves. A holdup problem arises because banks cannot commit to providing capital. To minimize competition, arbitrageurs will choose to stay constrained and underinvest in the arbitrage unless banks have sufficient reputational capital. This problem arises when mispricing is largest. More competition among financiers, higher arbitrageur wealth, and allowing for explicit contracts can worsen the holdup problem. When arbitrage is risky, financial relationships are more valuable, mitigating the problem.

Original languageEnglish (US)
Pages (from-to)2095-2138
Number of pages44
JournalReview of Finance
Volume19
Issue number6
DOIs
StatePublished - Oct 2015
Externally publishedYes

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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