Arbitrage and Endogenous Market Integration

We analyze a general equlibrium model of strategic arbitraging and intermediation. Arbitrageurs take advantage of mispricings, market frictions and manipulation opportunities in order to maximize profits. We analyze the effects of increased competition among arbitrageurs due to lower entry costs. Typically, markets become more liquid and integrated, and Cournot-Walras equilibria converge to Walrasian equilibria, though not uniformly: mispricings persist longer on shallow markets. We also provide a class of economies where the limiting equilibria are neither integrated nor Walrasian. Furthermore, we show that the asset pricing implications for financial innovations are quite different from standard models.

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