Financial Relationships and the Limits to Arbitrage

We propose a model of limited arbitrage based on financial relationships. Financially constrained arbitrageurs may choose to seek additional financing from banks that have the technology to profit from the strategies themselves. A holdup problem arises because banks cannot commit to providing capital. To minimize competition, arbitrageurs will choose to stay constrained and underinvest in the arbitrage unless banks have sufficient reputational capital. This problem arises when mispricing is largest. More competition among financiers, higher arbitrageur wealth, and allowing for explicit contracts can worsen the holdup problem. When arbitrage is risky, financial relationships are more valuable, mitigating the problem.