The Dynamics of Limits to Arbitrage: Evidence from International Cross-Sectional Data
46 Pages Posted: 16 Mar 2011 Last revised: 11 Jan 2013
Date Written: March 22, 2012
The Law of One Price suggests a simple arbitrage relationship that links prices of Treasury bonds when issued by the same issuer in different currency denominations. This relationship was widely violated during the 2007-2008 Financial Crisis. In this paper, we use international cross-sectional data on this phenomenon to learn about the relative importance of different models of limits to arbitrage. A key source of information is a unique dataset that provides details on the cost of borrowing and the inventory of lendable bonds at brokers-dealers. We focus on four main explanations of limits to arbitrage: (i) Liquidity risk, (ii) Short-selling constraints, (iii) Leverage constraints and funding costs, (iv) Institutional frictions in the context of a large macro demand and wealth shock. We find that bond specific liquidity costs and short-selling constraints have only a limited ability to explain the observed elevated basis. Instead, we find stronger evidence of an interaction between leverage constraints and funding costs in the presence of a large macro shock reducing the supply of risk capital. In addition, we find that the geographical distribution and concentration of bank holdings of these bonds help to explain cross-sectional differences in the Basis. Finally, we quantify the extent to which monetary policy interventions helped to reduce these frictions.
Keywords: Limits to Arbitrage, Market Anomalies, Liquidity, Financial Constraints
JEL Classification: G01, G12
Suggested Citation: Suggested Citation