Financially Constrained Strategic Arbitrage

We develop an equilibrium model of strategic trading under …nancial constraints. Investors have access to a fundamentally riskless arbitrage opportunity, but may be forced to …re-sell if their capital does not fully cover their losses. Investors internalize both their price impact and the e¤ect of price movements on the constraints of all market participants, giving rise to a strategic motive for the less exposed investors to induce …re-sales of more exposed ones. Ex ante, the presence of predatory risk leads to lower investment by all traders. We show the implications of strategic trading on price dynamics, returns characteristics, and leverage cross-section and dynamics. Keywords: limits to arbitrage, liquidity, wealth e¤ects, strategic trading, endogenous risk JEL Classi…cation: C72, D43, G10 Preliminary version. We thank Christian Hellwig, Pete Kyle, Péter Kondor, Lasse Pedersen, Adam Reed, Rohit Rahi, Alp Simsek, Dimitri Vayanos, Andrea Vedolin, Kathy Yuan, and seminar participants at CBS, IE-HAS, and LSE for helpful comments. Emails: aytek.malkhozov@frb.gov, gv.…@cbs.dk.