Arbitrage and Its Limits

Abstract

Unlike standard asset pricing theory which assumes frictionless arbitrage, the ‘limits of arbitrage’ theory of financial markets studies the asset pricing, liquidity and welfare implications of the constraints faced by real-life arbitrageurs such as hedge funds and other financial intermediaries. Among other results, it can explain amplification and cross-market contagion episodes, sudden liquidity dry-ups and liquidity linkages across markets, and offers a useful framework for public policy analysis.