Limits to arbitrage
Encyclopedia
Limits to arbitrage is a theory
that, due to restrictions that are placed on funds that would ordinarily be used by rational traders
to arbitrage
away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time.
The efficient market hypothesis
assumes that whenever mispricing of a publicly-traded stock
occurs, an opportunity for low-risk profit
is created for rational traders. The low-risk profit opportunity exists through the tool of arbitrage
, which, briefly, is buying and selling differently priced items of the same value, and pocketing the difference. If a stock falls away from its equilibrium price (let us say it becomes undervalued) due to irrational trading (noise trader
s), rational investors will (in this case) take a long position
while going short a proxy security, or another stock with similar characteristics.
Rational traders usually work for professional money management firms
, and invest
other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency.
Long-Term Capital Management
became a victim of limits to arbitrage in 1998. It took bets on the convergence of the prices of certain bonds. These bond prices were guaranteed to converge in the long run. However, in the short run, because of the East Asian crisis and the Russian government's default on its debt, panicked investors traded against LTCM's position, driving prices that should have converged further apart. This caused LTCM to face margin calls. Because they did not have enough money to cover these calls, they were compelled to close out their positions at huge losses, even though, had they held on to their positions, they would have made significant profits.
Andrei Shleifer and Robert W. Vishny, 1997, 'The Limits of Arbitrage', The Journal of Finance, American Finance Association
Gromb, Denis, and Dimitri Vayanos, 2002, Equilibrium and welfare in markets
with financially constrained arbitrageurs, Journal of Financial
Economics 66, 361-407.
Gromb, Denis, and Dimitri Vayanos, 2010, “Limits of Arbitrage: The State of the Theory”, the Annual Review of Financial Economics, forthcoming.
Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of Convergence Trading
Journal of Finance 64(2), April 2009
Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of Financial Economics 62, 247-292.
Theory
The English word theory was derived from a technical term in Ancient Greek philosophy. The word theoria, , meant "a looking at, viewing, beholding", and referring to contemplation or speculation, as opposed to action...
that, due to restrictions that are placed on funds that would ordinarily be used by rational traders
Stock trader
A stock trader or a stock investor is an individual or firm who buys and sells stocks in the financial markets. Many stock traders will trade bonds as well...
to arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time.
The efficient market hypothesis
Efficient market hypothesis
In finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient". That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.There are...
assumes that whenever mispricing of a publicly-traded stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
occurs, an opportunity for low-risk profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
is created for rational traders. The low-risk profit opportunity exists through the tool of arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
, which, briefly, is buying and selling differently priced items of the same value, and pocketing the difference. If a stock falls away from its equilibrium price (let us say it becomes undervalued) due to irrational trading (noise trader
Noise trader
A noise trader also known informally as idiot trader is described in the literature of financial research as a stock trader whose decisions to buy, sell, or hold are irrational and erratic...
s), rational investors will (in this case) take a long position
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
while going short a proxy security, or another stock with similar characteristics.
Rational traders usually work for professional money management firms
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
, and invest
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency.
Long-Term Capital Management
Long-Term Capital Management
Long-Term Capital Management L.P. was a speculative hedge fund based in Greenwich, Connecticut that utilized absolute-return trading strategies combined with high leverage...
became a victim of limits to arbitrage in 1998. It took bets on the convergence of the prices of certain bonds. These bond prices were guaranteed to converge in the long run. However, in the short run, because of the East Asian crisis and the Russian government's default on its debt, panicked investors traded against LTCM's position, driving prices that should have converged further apart. This caused LTCM to face margin calls. Because they did not have enough money to cover these calls, they were compelled to close out their positions at huge losses, even though, had they held on to their positions, they would have made significant profits.
Additional reading
Inefficient Markets: An Introduction to Behavioral Finance, Andrei Shleifer, 2000, Oxford University Press.Andrei Shleifer and Robert W. Vishny, 1997, 'The Limits of Arbitrage', The Journal of Finance, American Finance Association
Gromb, Denis, and Dimitri Vayanos, 2002, Equilibrium and welfare in markets
with financially constrained arbitrageurs, Journal of Financial
Economics 66, 361-407.
Gromb, Denis, and Dimitri Vayanos, 2010, “Limits of Arbitrage: The State of the Theory”, the Annual Review of Financial Economics, forthcoming.
Kondor, Peter, 2009. Risk in Dynamic Arbitrage: Price Effects of Convergence Trading
Journal of Finance 64(2), April 2009
Xiong, Wei, 2001, Convergence trading with wealth effects, Journal of Financial Economics 62, 247-292.