Holding Costs and Equilibrium Arbitrage
This paper constructs a dynamic model of the equilibrium determination of relative prices when arbitragers face holding costs. The major findings are that 1) models based on riskless arbitrage arguments alone may not provide usefully tight bounds on observed prices, 2) arbitragers are often most effective in eliminating the mispricings of shorter-term assets, 3) arbitrage activity increases the mean reversion of changes in the mispricing process and reduces their conditional volatility, and 4) there may be “spillovers” in arbitrage activity, i.e. profits per arbitrager in a given market may increase with the number of arbitragers. Finally, several predictions of the model are consistent with the growing empirical literature on deviations of prices from fundamental values.