Financial Economics

21

IMPEDIMENTS TO ARBITRAGE

This chapter explores market relations when there are impediments to arbitrage. It begins by explaining how markets differ in providing liquidity. If all markets were perfectly liquid and there were no transactions costs, asset prices would be related as in the no-arbitrage world. However, with differing degrees of information, of liquidity, and in the presence of transactions costs, asset price relations become very much less well defined, as Chapter 20 indicated. Furthermore, these same market imperfections can lead to a number of phenomena, including credit rationing equilibria, market segmentation, market failure, and financial system externalities.

In an arbitrage-free world, securities are always liquid, all market transactions are linked by arbitrage, externalities (i.e., third-party effects) and market failures are assumed away. The assumptions are important both in their own right and for analyzing some of the complications arising when the assumptions do not hold. Market imperfections can imply that market prices are no longer completely linked to each other, that the liquidity of securities can vary, and that externalities (third-party effects) may influence prices. Sometimes equilibrium prices may not be attainable; in other cases, market failure can occur and no transactions will take place at all.

Despite the foregoing complications, the prices determined in arbitrage-free markets can still serve as a guide to value, although depending ...