Arbitrage Chains

James Dow, Gary Gorton

NBER Working Paper No. 4314
Issued in April 1993
NBER Program(s):   AP

In efficient markets the price should reflect the arrival of private information. The mechanism by which this is accomplished is arbitrage. A privately informed trader will engage in costly arbitrage, that is, trade on his knowledge that the price of an asset is different from the fundamental value if: (1) his order does not move the price immediately to reflect the information; (2) he can hold the asset until the date when the information is reflected in the price. We study a general equilibrium model in which all agents optimize. In each period, there may be a trader with a limited horizon who has private information about a distant event. Whether he acts on his information, and whether subsequent informed traders act, is shown to depend on the possibility of a sequence or chain of future informed traders spanning the event date. An arbitrageur who receives good news will buy only if it is likely that, at the end of his trading horizon, a subsequent arbitrageur's buying will have pushed up the expected price. We show that limited trading horizons result in inefficient prices because informed traders do not act on their information until the event date is sufficiently close.

download in pdf format
   (324 K)

download in djvu format
   (221 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w4314

Published: Dow, James and Gary Gorton. "Arbitrage Chains," Journal of Finance, 1994, v49(3), 819-849. citation courtesy of

Users who downloaded this paper also downloaded* these:
Greenwood and Nagel w14111 Inexperienced Investors and Bubbles
Shleifer and Vishny w5167 The Limits of Arbitrage
Vissing-Jorgensen Perspectives on Behavioral Finance: Does "Irrationality" Disappear with Wealth? Evidence from Expectations and Actions
Froot, Scharfstein, and Stein w3250 Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation
Gromb and Vayanos w15821 Limits of Arbitrage: The State of the Theory
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us