Financially constrained strategic arbitrage

This paper develops an equilibrium model of strategic arbitrage under wealth constraints. Arbitrageurs optimally invest into a fundamentally riskless arbitrage opportunity, but if their capital does not fully cover losses, they are forced to close their positions. Strategic arbitrageurs with price impact take this constraint into account and try to induce the \u85re sales of others by manipulating prices. I show that if traders have similar proportions of their capital invested in the arbitrage opportunity, they behave cooperatively. However, if the proportions are very di¤erent, the arbitrageur who is less invested predates on the other. The presence of other traders thus creates predatory risk, and arbitrageurs might be reluctant to take large positions in the arbitrage opportunity in the \u85rst place, leading to an initially slow convergence of prices. JEL Classi\u85cation: C72, D43, G10