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Externalities as Arbitrage
Externalities as Arbitrage
October 7,2020Working Paper No. 3632
How can we assess whether macro-prudential regulations are having their intended effects? If these regulations are optimal, their marginal benefit of addressing externalities should equal their marginal cost of distorting risk-sharing. These risk-sharing distortions will manifest as trading opportunities that constrained intermediaries are unable to exploit. Focusing in particular on arbitrage opportunities, I construct an “externality-mimicking portfolio” whose returns track the externalities that would rationalize existing regulations as optimal. I conduct a revealed-preference exercise using this portfolio and test whether the recovered externalities are sensible. I find that the signs of existing CIP violations are inconsistent with optimal macro-prudential policy.