Finance 361

Workshop 4

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Workshop 4 Question 1 (2015 S2 Midterm Q1)
Consider a perfectly competitive market with no trading
frictions, no taxes, no private information, no trading
constraints, no arbitrage, unlimited availability of capital
and fully rational market participants with an unlimited
ability to process information. In such a fictional setting,
prices fully reflect available information – there is no
mispricing.

Which of the above assumptions would you need to

remove in order to obtain a market in which persistent
mispricing can occur? Explain by way of example how
mispricing could occur in your revised market. [5 Marks]

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Workshop 4 Question 1 (2015 S2 Midterm Q1)
In order for persistent mispricing to occur, the market
would require the presence of/be dominated by irrational
investors who make suboptimal decisions.

In addition, market frictions must also exist that inhibit

rational investors from performing arbitrage that eliminates
mispricing.

For example:
Taxes
Private information
Trading constraints, etc.

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Workshop 4 Question 2 (2016 S1 Midterm Q1)
Compare and contrast asymmetric information and
bounded rationality in the context of market frictions.

In particular, what are the similarities and differences

between these two concepts? [5 Marks]

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Workshop 4 Question 2 (2016 S1 Midterm Q1)
Similarities:
1) Both are market frictions and sources of market
inefficiencies.
2) Both are related to information.

Differences:
Asymmetric information is the possibility that on some
market participants have more information than others
(e.g., information on the true value of an asset). It can
reduce efficiency of markets or even cause market
collapse.

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Workshop 4 Question 2 (2016 S1 Midterm Q1)
Differences continued:
Bounded rationality relates to the limits of market
participants’ ability to process available information.

There are limits to what we could extract from the

information available due to limited
knowledge/time/resources. This means that not all
available information is accurately reflected in traded
prices.

In sum: asymmetry information is related to information

availability, while bounded rationality is to do with
information processing.

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Workshop 4 Question 3 (2017 S2 Midterm Q5)
“The impact of behavioural biases on equilibrium returns
depend critically on the presence of limits to arbitrage.” Is
this true? Discuss. [5 Marks]

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Workshop 4 Question 3 (2017 S2 Midterm Q5)
Behavioural biases are the limitations that affect
investors in their investment decisions.

If there are no limits to arbitrage, the effect of behavioural

biases on equilibrium returns should be small.

Rational investors will arbitrage away any mispricing’s and

move expected returns towards equilibrium level.

However, if limits to arbitrage exist, rational investors will

be restricted from trading away mispricing.

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Workshop 4 Question 4 (2019 S2 Midterm Q5)
A substantial fraction of German government bonds are
currently trading at negative yields. This means that if you
buy them now and hold them to maturity, you would
receive LESS in total than you initially paid for them.

a) Design a risk-free arbitrage strategy for investing 1

billion euros. Assume perfectly frictionless markets
(including unlimited short-selling without posting
collateral). Assume you have a physical safe that is really
100% safe and doesn’t cost you anything to own and
operate. [3 Marks]

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Workshop 4 Question 4 (2019 S2 Midterm Q5)
Short the negative yielding bonds.

Put the cash proceeds in your safe.

Use the money in the safe to meet coupon payments and

principal repayment at maturity.

There will be money left in the safe after repayment of

coupons and principal since it traded a negative yield – an
arbitrage, since you did not start with any money.

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Workshop 4 Question 4 (2019 S2 Midterm Q5)
b) Drawing on your understanding of market frictions and
limits to arbitrage, what possible reasons could there be
for real-world investors to invest billions in these bonds
nonetheless? Note calling investors stupid is not a valid
reason, no matter how satisfying you may find it. (And the
correct term is boundedly rational, not stupid.) [4 Marks]

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Workshop 4 Question 4 (2019 S2 Midterm Q5)
• Short horizons
Investors will only lose money for sure if they hold the
bonds to maturity – in the meantime yields may become
even more negative, yielding a profit if the bonds are then
sold.

• Real-world cost of physical cash storage

You will need “mission impossible” level security for the
billion dollars in cash you hold - this will not be cheap, and
in fact it may be a lot more expensive than simply bearing
the negative yield.

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Workshop 4 Question 4 (2019 S2 Midterm Q5)
• Liquidity
German bonds are highly liquid and can be turned into
electronic cash with a few keystrokes or a phone call.

Strangely, this is not true for physical cash in this amount –

you are unlikely to find a reputable market participant
happy to accept $1 bn in payment in used 20-dollar notes.

Any other reasons?