THE LIMITS OF ARBITRAGE

Textbook arbitrage in financial markets requires no capital and entail s no risk. In reality, almost all arbitrage requires capital, and is t ypically risky. Moreover, professional arbitrage is conducted by a rel atively small number of highly specialized investors using other peopl e's capital. Such professional arbitrage has a number of interesting i mplications for security pricing, including the possibility that arbit rage becomes ineffective in extreme circumstances, when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them.