& ^ewey Working Paper Alfred P. Sloan School of Management Holding Costs and Equilrerium Arbitrage Holding Costs and Equilrerium Arbitrage Holding Costs and Equilibrium Arbitrage

This paper constructs a dynamic model of the equilibrium determination of relative prices when risk averse arbitragers face holding costs. The major fmdings are as follows: 1) Arbitragers reduce but do not eliminate mispricings. 2) Because arbitragers optimally take positions when mispricings are within the riskless arbitrage bounds, models based on riskless arbitrage arguments alone may not provide usefully tight bounds on observed prices. 3) Arbitragers are least effective in eliminating the mispricings of long-term assets. 4) Arbitrage activity is most effective when exogenous shocks are transient and conditionally volatile. 5) Arbitrage activity reduces the conditional volatility of the mispricing process but may increase or decrease its mean reversion. Furthermore, in the presence of arbitragers, both conditional volatility and mean reversion are non-linear functions of the level of