Does Arbitrage Flatten Demand Curves for Stocks?

2002/10/01 by Jeffrey Wurgler, Ekaterina Zhuravskaya · 8 citations
Economics, Econometrics and Finance · #Financial Markets and Investment Strategies #Monetary Policy and Economic Impact #Housing Market and Economics

paper · doi:10.1086/341636

Abstract

In textbook theory, demand curves for stocks are kept flat by riskless arbitrage between perfect substitutes. In reality, however, individual stocks do not have perfect substitutes. We develop a simple model of demand curves for stocks in which the risk inherent in arbitrage between imperfect substitutes deters risk-averse arbitrageurs from flattening demand curves. Consistent with the model, stocks without close substitutes experience higher price jumps upon inclusion into the S&P 500 Index. The results suggest that arbitrage is weaker and mispricing is likely to be more frequent and more severe among stocks without close substitutes.

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