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Vol. 84, No. 6
Posted 2002-11-01

Asset Mispricing, Arbitrage, and Volatility

by William R. Emmons and Frank A. Schmid

Market efficiency remains a contentious topic among financial economists. The theoretical case for efficient markets rests on the notion of risk-free, cost-free arbitrage. In real markets, however, arbitrage is not risk-free or cost-free. In addition, the number of informed arbitrageurs and the supply of financial resources they have to invest in arbitrage strategies is limited. This article builds on an important recent model of arbitrage by professional traders who need—but lack—wealth of their own to trade. Professional arbitragers must convince wealthy but uninformed investors to entrust them with investment capital in order to exploit mispricing and push market prices back toward intrinsic value. The authors introduce an objective function for the arbitrageur that resembles real-world contracts. Also, the authors calibrate the objective functions to show that arbitrage generally has a price-stabilizing influence and reduces volatility in asset returns.

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