Limits of Arbitrage: The State of the Theory

Abstract

We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research. and CEPR and also NBER d.vayanos@lse.ac.uk 1 for a more limited set of assets, partly because of the scarcity of asset pairs with closely related payoffs. At the same time, these anomalies are particularly hard to reconcile with standard models.Indeed, while standard models may offer slightly different predictions as to how risk and expected returns are related, they all imply the law of one price, i.e., assets with identical payoffs must trade at the same price. In the previous examples, however, differences in payoffs appear to be insignificant relative to the observed price differences. Understanding why anomalies exist and are not eliminated requires a careful study of the process of arbitrage: who are the arbitrageurs, what are the constraints and limitations they face, and why arbitrage can fail to bring prices close to the fundamental values implied by standard models. This is the focus of a recent literature on the limits of arbitrage. This article surveys important theoretical developments in that literature, nests them within a simple model, and suggests directions for future research. Limits of arbitrage are commonly viewed as one of two building blocks needed to explain anomalies. The other building block are demand shocks experienced by investors other than arbitrageurs. Anomalies are commonly interpreted as arising because demand shocks push prices away from fundamental values and arbitrageurs are unable to correct the discrepancies. Such "non-fundamental" shocks to demand are often attributed to investor irrationality. In this sense, research on the limits of arbitrage is part of the behavioral finance agenda to explain anomalies based on investors' psychological biases. 3 This article departs from the conventional view in two related respects. First, it argues that research on the limits of arbitrage is relevant not only for behavioral explanations of anomalies but also for the broader study of asset pricing. Indeed, psychological biases are not the only source of non-fundamental demand shocks: such shocks can...

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