BMME115 Behavioral Finance

Lecture 2

The Limits of Arbitrage

Dr. Li He
Rotterdam School of Management

MScFI program
Limit to Arbitrage References

Pick-a-Number Game

I Imagine yourself in a contest, where you are to choose a whole

number between 0 and 100 as your entry.
I The winner will be the person whose choice comes closest to
two-thirds of the average entry.
What number would you enter?

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The Arbitrage Critique

I Irrational investors cannot have a substantial, long-lived impact

on prices.
I Rational investors, or “arbitrageurs,” who trade aggressively
against the mispricing, causing it to disappear.

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In Practice: AQR Capital Management

AQR Capital Management

I It is the 2nd largest hedge fund in the US 2018 ranked by assets under
management ($203 billion in 2019);
I It has deep roots in academia: 45% of the AQR’s employees have earned
advanced degrees, with 80 holding PhDs.

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In Practice: AQR Capital Management

Betting Against Beta [Frazzini and Pedersen, 2014]

I Strategy Betting against beta (BAB) factor: hold low-beta assets, and
short high-beta assets.
I Theory Many investors are constrained in the leverage that they can take,
and they therefore overweight risky securities instead of using leverage.
I Empirics The BAB factor has highly significant risk-adjusted returns,
accounting for its realized exposure to market, value, size, momentum, and
liquidity factors (i.e., significant one-, three-, four-, and five-factor alphas).

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In Practice: AQR Capital Management

Source: Novy-Marx and Velikov (2018).

The figure shows the performance of BAB with and without transaction costs. The sample covers January 1968
through December 2017.

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Costs and Risks of Arbitrage (1/2)

I Fundamental risk Arbitrageurs may identify a mispricing of a

security that does not have a close substitute that enables
riskless arbitrage.
I Noise-trader risk Once a position is taken, noise traders may
drive prices further from fundamental value, and arbitrageurs
may be forced to invest additional capital, which may not be
available, forcing an early liquidation of the position.

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Costs and Risks of Arbitrage (2/2)

I Synchronization risk An arbitrageur who detects the

overvaluation may be reluctant to trade against it because he
does not know how many other hedge funds are aware of the
mispricing.
I Implementation costs Arbitrageurs face transaction costs and
the cost of discovering a mispricing.

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An Illustrative Example

Twin Shares: Royal Dutch and Shell in 1907

I Royal Dutch and Shell are independently incorporated in the Netherlands

and England, respectively;
I The structure has grown “out of a 1907 alliance” between Royal Dutch and
Shell Transport by which the two companies agreed to merge their interests
on a 60:40 basis while remaining separate and distinct entities (Royal
Dutch 20 F, 1994, p. 1);

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An Illustrative Example

Twin Shares: Royal Dutch and Shell in 1907

Source: Froot and Dabora [1999].

This figure shows on a percentage basis the deviations from theoretical parity of Royal Dutch and Shell shares and
ADRs traded on the NYSE. Data are from the Center for Research in Security Pricing (CRSP).

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An Illustrative Example

Twin Shares: Royal Dutch and Shell in 1907

Knowing that:
I Several hedge funds, Long-Term Capital Management included, did try to
exploit this phenomenon;
I Shorting shares of either company was an easy matter.

Why might arbitrage be limited?

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Reference I

Frazzini, A. and Pedersen, L. (2014). Betting against beta. Journal of

Financial Economics, 111(1):1–25.
Froot, K. A. and Dabora, E. M. (1999). How are stock prices affected by the
location of trade? Journal of Financial Economics, 53(2):189–216.

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