Munich Personal RePEc Archive

Uses and Misuses of Arbitrage in Financial Theory, and a Suggested Alternative

García Iborra, Rafael and Howden, David (2016): Uses and Misuses of Arbitrage in Financial Theory, and a Suggested Alternative. Published in: Journal of Prices & Markets , Vol. 2, No. 4 (2016): pp. 44-57.

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Despite being a mainstay of modern economic theory, the simple concept of arbitrage is sorely misused. In this paper we overview such instances, and offer an alternative definition. Most applications of arbitrage use it as a general equilibrating tendency irrespective of whether the outcome is certain. Alternatively, it can be used in a rather “loose” manner to apply to inter-temporal scenarios or situations involving multiple (though similar) goods. To accommodate some of these instances we redefine the concept as any case where “one or more assets are simultaneously exchanged, locking in a monetary profit with certainty at the time of trading, even if it cannot be certain as to the magnitude of such profit.” We outline the scenarios where this revised definition matters, not least of which is constricting the use of arbitrage to its proper domain within the context of entrepreneurship as a cause of price formation.

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