The capital constraints of sophisticated investors affect the functioning of financial markets.
To study how, we propose a discrete time infinite horizon equilibrium model of
financial markets in which arbitrageurs exploit different riskfree arbitrage opportunities
provided by pairs of twin assets trading in segmented markets. Doing so, arbitrageurs
reduce market segmentation, narrowing the price gap between twin assets, and providing
liquidity to other market participants. The arbitrageurs, however, face financial
constraints that limit their investment capacity: they must collateralize fully and separately
each leg of an arbitrage trade. We characterize the joint equilibrium dynamics
of arbitrage capital and arbitrage profitability, show how the profitability of arbitrage
strategies, market liquidity and arbitrageurs’ positions depend on the capital available
for arbitrage, and derive cross-sectional and time-series properties of these variables.