Arbitrageurs, bubbles and credit conditions

This paper studies a pure exchange economy populated by three types of agents: constrained agents who are subject to participation constraints, unconstrained agents who are only subject to a standard solvency constraint, and arbitrageurs who, in addition to being unconstrained, may incur transitory losses that are bounded by a state-dependent credit limit. We show that this credit possibility is valuable when there are asset pricing bubbles, which arise endogenously due to the presence of constrained agents, and that the bubble on the stock vanishes in the limit of infinite credit. In contrast to previous results in the literature, we show that the presence of risky arbitrage trading makes the stock more volatile and generates a leverage effect.