Rational limits to arbitrage

It is often argued that asset prices exhibit patterns incompatible with the behaviour of rational, optimising agents. This paper proposes a rational framework which generates asset prices which appear irrational. This is accomplished by studying rational expectations equilibria in the presence of two realistic market frictions: immediacy risk (agents have to submit their demand functions before they know the equilibrium price) and asset-specific orders (investors have to submit one separate demand for each asset, which may not be contingent upon the prices of the other assets). We study some properties of such equilibria, in particular the prevalence of arbitrage and of informational inefficiencies. 

Download