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Question 4

Discuss the limits to arbitrage. Your answers should include theoretical as well as
real-world examples.
Definition of arbitrage: * the simultaneous purchase and sale of an asset in order to
profit from a difference in the price.
* It is a trade that profits by exploiting price differences of identical or similar
financial instruments, on different markets or in different forms.
* Arbitrage exists as a result of market inefficiencies; it provides a mechanism to
ensure prices do not deviate substantially from fair value for long periods of time.

Limits to arbitrage
Theoretical issues

1. Fundamental risk
Often there are no identical assets that have identical cashflows. Arbitrageur is
therefore exposed to fundamental risk. i.e. the asset they buy and short are not
identical therefore exposed to different risks.
2.Noise trader risk
Noise traders that drive prices away from fundamental values can continue to be
overly optimistic or pessimistic so mispricing can remain
3.Implementation costs
Borrowing costs associated with shorting can be to high to justify arbitrage

5. The theory of the LIMITS TO ARBITRAGE:

The question that remains to be answered is why arbitrage opportunities do not
quickly disappear even if investors know how to exploit them?. The idea is that
strategies designed to correct the mispricing can be both risky and costly. Professors
Thaler and Barberis (Thaler and Barberis [36]) have identified four risks and costs
that have been identified.
1. Fundamental Risk
Fundamental risk refers to the risk that new bad information arrives to the market
after you purchased the security. Theoretically this risk could be perfectly hedged by
buying a closely related product. Unfortunately substitute securities are rarely perfect,
making it impossible to remove all the fundamental risk.
As an example, suppose you own two shares, one from A, the other one from B.
Furthermore assume that both are closely related, share the same industry, and that
you buy A and sell B. After the combination of buying and selling, most fundamental
risk is removed. Intuitively, we can think of being neutral to the industry where A and
B operate. However, the investor is still vulnerable to bad news about the industry as a
whole. To sum up, fundamental risk always persists even though there are ways of
hedging the portfolio against it.
2. Noise Trader Risk
Originally introduced by De Long et al. (1990) [12] and by Shleifer and Vishny
(1997) [33], noise trader risk refers to the risk that the mispricing worsens in the short
run because there is a possibility that pessimistic traders become even more
pessimistic about the future.
Noise trader risk is very important because of its link to other agency problems. It can
force people, such as institutional investors and hedge fund managers, to liquidate
their positions early, bringing them unwanted and unnecessary steep losses. Hence if
investors lack the knowledge to evaluate the managers strategy, they may simply
evaluate him based on his returns. If a mispricing worsens in the short run and
generates negative returns, investors made decide to withdraw their funds and force
him to liquidate his business.
Professors Thaler and Barberis argue that fear of such premature liquidation makes
professional managers be less aggressive in combating the mispricing in the first
place. Although noise risk most commonly occurs when shorting assets, it may also

be present in the collateral of a repurchase agreement (repo) or if the original owner

of the stock demands his stock before our strategy corrected the mispricing.
Furthermore Professors Shleiffer and Summers (Shleiffer and Summers (1990) [32])
call this source of risk: resale risk because it comes from the unpredictability of
future resale prices. This risk will particularly affect investors and professional
managers time horizon. In particular, if resale risk is high, investors will have a
3. Implementation Costs
Implementation costs are well known to any investor. They refer to transaction costs
such as commissions, bid-ask spread, premium costs for hot collateral in repurchase
agreements, increased commissions for shorting securities among others. Other than
monetary costs, there can also be legal constraints and accounting issues.
This category also includes the cost of finding and learning about a mispricing, as
well as the cost of the resources needed to exploit it. In particular, finding mispricing
can be expensive and time consuming. Learning about them will certainly require
highly specialized labor. Finally exploiting mispricing furthermore requires state of
the art technology and expensive IT systems that can trade at the high-frequency

Problems with arbitrage

Transaction costs such as commissions, bid-ask spreads and price impact can
make arbitrage opportunities less attractive

Short-selling is often essential (see example) in arbitrage

A fee is charged for borrowing a stock, generally small

But fees can be very high

May not be able to find shares to borrow at any price...

Some money managers (pension fund and mutual fund managers)

are not allowed to short-sell

These different factors cause limits to arbitrage, which can cause mispricing of
assets to continue, which goes against the EMH.

Who are arbitrageurs?

A type of investor who attempts to profit from price inefficiencies in the market by
making simultaneous trades that offset each other and capturing risk-free profits. An
arbitrageur would, for example, seek out price discrepancies between stocks listed on
more than one exchange, and buy the undervalued shares on one exchange while short
selling the same number of overvalued shares on another exchange, thus capturing
risk-free profits as the prices on the two exchanges converge.
Arbitrageurs are typically very experienced investors since arbitrage opportunities are
difficult to find and require relatively fast trading. Arbitrageurs also play an important
role in the operation of capital markets, as their efforts in exploiting price
inefficiencies keep prices more accurate than they otherwise would be.

Evidence from Scruggs 2007:

Analyzing DLS makes it easy to discover anything extra that may be affecting the
prices, and Scruggs puts this down to noise.
He studies two aspects:
* Total return variation thats unrelated to fundamentals
* Noise trader risk faced by arbitrageurs engaged in long-short pairs trading
Facts and data
Prior to 2005, Royal Dutch/Shell Group was jointly held by 2 holding companies:
1. Royal Dutch, domiciled in Netherlands, interest of 60% in the group
2. Shell Transport, domiciled in UK, interest of 40% in group
* Dividends were divided on a 60:40 basis. This gives a theoretical parity relationship
between the stock prices of both holding companies

If law of one price holds:

Theoretical parity = 0.6 * shell share price / 0.4 * Dutch share price
In theory, parity = 1
Deviation from parity = TP Actual parity

Continuation of Scrugg 2007:

Unilever NV and Unilever PLC

Twin parent companies of Unilever Group.

2 firms share the same BoD, reporting periods and accounting policies.

Neither is allowed to issue or reduce capital without permission from the


One NV share = 6.67*PLC shares

Parity relation between NV and PLC is fixed at 6.67:1

NV trade primarily in Amsterdam, PLC primarily in London

So if PLC share = 1, theoretically NV share price = 6.67