Limits of Arbitrage

Mayank Joshipura

Theory Supporting Limits to

Arbitrage
Fundamental Risk Negative Shock
and no Perfect Substitute (e.g. Ford
and GM)
Noise Trader Risk Continued
Widespread Irrationality
Forced Liquidation (Separation of Brains
and Capital)
Horizon Risk timing risk
Trading in the Same Direction

Cont..
Implementation Costs
Commission
Bid/Ask Spread
Price Impact
Short Sell Costs
Fees
Volume Constraints
Legal Restraints

Identification Cost
Mispricing > Predictability

Evidence Supporting Limits to

Arbitrage
Mispricings Hard to Identify
Test of Mispricing => Test of Discount Rate Model

Twin Shares
Royal Dutch (60%) and Shell (40%)
Only Risk is Noise Traders

=> PriceRD = 1.5*PriceS

Cont.
Index Inclusions
Stock Price Jumps Permanently
3.5% Average

Fundamental Risk
Poor Substitutes (best R2 < 0.25)

Noise Trader Risk

Index Fund Purchases etc.

Cont.
Internet Carve-Outs
3Com Sells 5% of Palm in IPO, Will Spin
Off Remainder in 9 Months
1 Share of 3Com will own 1.5 Shares of
Palm
PPalm = $95
3Com should be $142
P3Com = $81
Value of 3Com Excluding Palm = -$60

Cont..
Internet Carve-Outs
3Com Sells 5% of Palm in IPO, Will Spin
Off Remainder in 9 Months
1 Share of 3Com will own 1.5 Shares of
Palm
PPalm = $95
3Com should be $142
P3Com = $81
Value of 3Com Excluding Palm = -$60

Cont..
Why?
Very Few Shares of Palm available to
Short
Arbitrage was Limited
Mispricing Persisted