Arbitrage Opportunities: a Blessing or a Curse?

This paper shows that arbitrage is limited if rational agents face uncertainty about completing their arbitrage portfolios. This "execution risk" arises in our model because there are slippages in asset prices as arbitrageurs compete for the limited supply of assets needed for a profitable arbitrage portfolio. This is distinct from the existing limits of arbitrage such as noise trader risk, fundamental risk and synchronization risk. As a consequence, rational arbitrageurs might wait for appropriate compensation for execution risk rather than correct the mispricing immediately.

This leads to the existence of arbitrage opportunities even in markets with perfect substitutes and convertibility. We show that execution risk is related to market illiquidity and the number of competing arbitrageurs. Economic evaluation analyses of arbitrage strategies suggest that profitable exploitation of arbitrage opportunities in such markets is rare in the presence of competition.

Sebastian Gryglewicz