Arbitrage With Holding Costs: A Utility-Based Approach




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    • Stern School of Business, New York University, and Sloan School of Management, Massachusetts Institute of Technology, respectively. We would like to thank participants in the University of Texas, Austin, New York University and Cornell University Finance Seminar Series, participants in the 1990 AFA and AFFI meetings, and an anonymous referee for helpful comments and suggestions. Finally, Jean-Luc Vila wishes to acknowledge financial support from the International Financial Services Research Center at the Sloan School of Management.


Unit time costs, or holding costs, are incurred in many arbitrage contexts. Examples include losing the use of short sale proceeds and lending funds at below market rates in reverse repurchase agreements. This paper analyzes the investment problem of a risk averse arbitrageur who faces holding costs. The model allows prices to deviate from “fundamental” values without allowing for riskless arbitrage opportunities. After characterizing an arbitrageur's optimal strategy, the model is examined in the context of the Treasury market. The analysis reveals that holding costs are an important friction in this market and that they can significantly affect arbitrageur behavior.