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Arbitrage With Holding Costs: A Utility‐Based Approach
Author(s) -
TUCKMAN BRUCE,
VILA JEANLUC
Publication year - 1992
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1992.tb04658.x
Subject(s) - arbitrage , treasury , context (archaeology) , microeconomics , economics , investment (military) , business , financial economics , paleontology , archaeology , biology , politics , political science , law , history
Unit time costs, or holding costs, are incurred in many arbitrage contexts. Examples include losing the use of short sale proceeds and lending funds at below market rates in reverse repurchase agreements. This paper analyzes the investment problem of a risk averse arbitrageur who faces holding costs. The model allows prices to deviate from “fundamental” values without allowing for riskless arbitrage opportunities. After characterizing an arbitrageur's optimal strategy, the model is examined in the context of the Treasury market. The analysis reveals that holding costs are an important friction in this market and that they can significantly affect arbitrageur behavior.