Modern Financial Systems: Theory and Applications

CHAPTER 10

Markets with Impediments to Arbitrage

Chapter 10 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, 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. Furthermore, these same market imperfections can lead to such phenomena as credit rationing equilibriums, market segmentation, market failure, and financial system externalities.

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

Despite the foregoing complications, the prices determined in arbitrage-free markets can still serve as a guide to value, although depending on circumstances the guide can range from being helpful to being unreliable. This chapter attempts ...