A Reason for Sophisticated Investors not to seize Arbitrage Opportunities in Markets without Frictions

Arbitrage opportunities exist when it is possible to generate a nonnegative income stream without incurring any costs. This is, for instance, the case when it is possible to buy a portfolio of assets that costs nothing today and that will yield a positive payoff in the future. It is a widespread belief that, as long as there are no market frictions, arbitrage opportunities cannot exist. The reason is that as long as they do exist, the demand for the portfolio of assets mentioned before will be very large, exceeding supply, which will drive the price of the portfolio up until arbitrage is no longer possible. Here we will show that this belief can be incorrect when preferences change over time. Since Strotz’s (1955–1956) discussion of behavior when preferences change over time, there has been an increasing interest in economic models that do account for changing preferences, including Akerlof (2002), Angeletos et al. (2001), Barro (1999), Frederick et al. (2002), Gul and Pesendorfer (2001), Harris and Laibson (2001), Herings and Rohde (2006), Krusell and Smith (2003), Krusell et al. (2002), Laibson (1997), Loewenstein and Prelec (1992), Luttmer and Mariotti (2003), O’Donoghue and Rabin (1999a, 1999b), Phelps and Pollak (1968), Rubinstein (2003), and Thaler and Benartzi (2004). When preferences change over time, several types of behavior can be distinguished. ∗Department of Economics, Maastricht University, P.O. Box 616, 6200 MD Maastricht, The Netherlands. E-mail: [email protected]