The Limits of Arbitrage

Courtney Dobek

Southern New Hampshire University

 The article I have chosen is about the limits of arbitrage done at Harvard in the journal of

finance. Textbook Arbitrage in financial markets requires no capital and entails no risk. In

reality, almost all arbitrage requires capital, and is typically risky [ CITATION Shl97 \l 1033 ]. This

is often the case with textbooks and their teaching methods and are a great way to teach

processes but it severely lacks the basic variables that come about in a real life situation (Shleifer

& Vishny, 1997). Professional arbitrage is conducted by a relatively small number of highly

specialized investors using other people’s capital (Shleifer & Vishny, 1997). With this,

professional arbitrage has a number of interesting implications for security, pricing, including the

possibility that arbitrage becomes ineffective in extreme circumstances when prices diverge far

from fundamental values (Shleifer & Vishny, 1997). The model also suggests where anomalies

in financial markets are likely to appear and why arbitrage fails to eliminate them (Shleifer &

Vishny, 1997). This article describes the workings of markets in which specialized arbitrageurs

invest the capital of outside investors, and where investors use arbitrageur’s performance to

ascertain their ability to invest profitably (Shleifer & Vishny, 1997). We show that such

specialized performance based arbitrage may not be fully effective in bringing security prices to

fundamental values, especially in extreme circumstances (Shleifer & Vishny, 1997). More

generally, specialized professional arbitrageurs may avoid extremely volatile arbitrage positions

(Shleifer & Vishny, 1997). Although such positions offer attractive average returns, the volatility

also exposes arbitrageurs to risk of losses and the need to liquidate the portfolio under pressure

from the investors in the fund (Shleifer & Vishny, 1997). The avoidance of volatility by

arbitrageurs also suggests a different approach to understanding persistent excess returns in

security prices (Shleifer & Vishny, 1997). Specifically, we expect anomalies to reflect not some

exposure of securities too difficult to measure macroeconomics risk, but rather high idiosyncratic
return volatility of arbitrage trades needed to eliminate the anomalies (Shleifer & Vishny, 1997).

This seems to be a more realistic view of arbitrage that can shed light on a variety of

observations in securities markets that are difficult to understand in more conventional models

(Shleifer & Vishny, 1997).

This article is a great example to truly get a look at real world situations in Arbitrage that

would give a more realistic view of it in work (Shleifer & Vishny, 1997). With the length and

multiple examples on how the real world works and with the application of variables not

available through strict textbook examples and problem solving, allowing a great template for

students to view the true workings of Arbitrage (Shleifer & Vishny, 1997).

With the examples of much more volatile Arbitrage positions, the students are able to

truly judge how effective it can be and how in some situations, it is not the preferred choice for a

financially focused individual (Shleifer & Vishny, 1997). While some markets may revolve

around it, this may not be the optimal route for many set ups and through this article it is shown

that while it can have a good return, this is not always typical and it can actually be a very risky

strategy for a company (Shleifer & Vishny, 1997).

Specifically stated by the article, younger, less experienced individuals in the industry

may jump at the risky high paying set ups and the more experienced professionals tend to go

towards the more stable, less risk associated market focus, this may be a good article for

financial hopefuls to possibly look at all of their options within the field involving Arbitrage

(Shleifer & Vishny, 1997).

While not every position will be involved with this sort of financial strategy and there is

plenty that can be gained from it while still a lot lost, this paper has quite a large amount of
information involving the financial strategy to give a very good picture for the college student to

make a sound decision as to whether they agree with the specifics that would be involved in a

position focused on Arbitrage or to walk away from it all together (Shleifer & Vishny, 1997).

Judging the document from that point of view, a lot can be learned from it compared to the

college style textbook and can help to gain an understanding of the financial world and to build

the understanding and application of financial positions that will be made available after

graduation (Shleifer & Vishny, 1997).

References
Shleifer, A., & Vishny, R. (1997, March). The Limits of Arbitrage. Retrieved from Harvard University:
http://scholar.harvard.edu/files/shleifer/files/limitsofarbitrage.pdf