The Limits of Arbitrage

ANDREI SHLEIFER and

ROBERT W.VISHNY
商学院 周 美 & 杜慧卿
ABSTRACT

 In reality，almost all arbitrage requires

capital, and is typically risky.
 Professional arbitrage is conducted by a
relatively small number of highly speciali-
zed investors using other’s capital.
 Arbitrage becomes ineffective in extreme
circumstances.
 Anomalies in financial markets.
Fundamental concepts

“The simultaneous purchase and sale of

the same, or essentially similar, security
in two different markets for advantage-
ously different prices.”
No risk and need no capital.
Realistic arbitrage are more complex

 Require capital good faith money

 In short run, one may lose money
 Different trading hours, settlement dates,
and delivery terms.
 If prices are moving rapidly, the value
may differ additional risks
PBA( performance-based arbitrage)

 More commonly, conducted by relatively

few professional, highly specialized
investors;
 Outside resources
 Brains and resources are separated
 Allocate funds based on past returns
I. An agency model of limited arbitrage

 Assume：
① Three types: noise traders, arbitrageurs,
and investors in arbitrage funds
② Fundamental value is V;
③ Three time periods
④ p t , St , F
t
⑤ QN(t )  [V  S t ] pt
I. An agency model of limited arbitrage

 Arbitrageurs‘ demand QA(2)  F2 p2

 Aggregate demand equals the unit
supply: p2  V  S 2  F2
 Not fully invest, D1
 QA(1)  D1 p1 , p1  V  S1  D1
 Market segment, T investors with $1, so
F2  T
I. An agency model of limited arbitrage

 Compete in the price the charge;

 Assume marginal cost constant, so
competition drives price to marginal cost
 Bayesians, allocate funds according to
past performance( PBA );
 An increasing function:
F2  F1 * G{( D1 F1 ) * ( p2 p1 )  ( F1  D1 ) F1}
I. An agency model of limited arbitrage

 Benchmark: zero return

 A linear function: G ( x)  ax  1  a ,with a  1
 Then F2  a{D1 * ( p2 p1 )  (F1  D1 )}  (1  a)F1  F1  aD1 (1  p2 p1 )
 If p1  p2, gain funds; or ,lose funds
 The higher is a , the more sensitive to
past performance
I. An agency model of limited arbitrage

An arbitrageur’s optimization problem:

q S 2  S  S1;
1-q S 2  0 , p2  V .
Maximize:
D1 * V
EW  (1  q ){a (  F1  D1 )  (1  a ) F1 }
p1
V D1 * p 2
 q ( ) * {(  F1  D1 )  (1  a ) F1 }
p2 p1
II. Performance-based Arbitrage and Market
Efficiency

 The case of a  1
first order condition:
V p V
(  1)  q( 2  1)
（1 - q） 0
p1 p1 p2

Inequality： D1  F1 ；
Equality： D1  F1 .
The initial displacement is large and will
recover with a high probability; if they fall,
it can’t be large. fully invested at 1
II. Performance-based Arbitrage and Market
Efficiency

Proposition 1:For a given V , S1 , S , F1 ;

and a , there is a q such that, for
*
q  q *
,
D  F , and for q  q , D1  F1 .
1 1
*

Proposition 2: At the corner solution( D1  F1 ),

dp1 dS1  0 , dp2 dS  0 , and dp1 dS  0 . At theinterior
solution, dp1 dS1  0 , dp2 dS  0 , and dp1 dS  0 .
It shows that arbitrageurs ability to bear
mispricing is limited, larger shocks, less
efficient.
II. Performance-based Arbitrage and Market
Efficiency

Uncertainty of the effect:

 a higher a could make market less
efficient, by withdrawing funds;
 A higher a will make prices adjust quickly
by giving more funds after a partial
reversal of the noise shock.
II. Performance-based Arbitrage and Market
Efficiency

Consider about the extreme circumstances:

two ways: D1  F2 ？ D1 p1  F2 p2 ？
Proposition 3：If arbitrageurs are fully
invested at t  1 , and noise trader mispe-
rceptions deepen att  2 , then, fora  1 ,
D F
1
, and D1 p1  F2 p2.
2

Fully invested arbitrageurs may face equity

withdrawals and liquidate.
II. Performance-based Arbitrage and Market
Efficiency

 Proposition 4: At the fully invested equili-

brium, dp2 dS  1 and p2 dadS  0 .
2
d

 This shows: prices fall more than one for

one with the noise trader shock at time
2,when fully invested at time 1.
 A market driven by PBA can be quite in-
effective in extreme circumstances.
III. Discussion of Performance-based Arbitrage

 We are uncertain about the significance

of PBA
 Funds decline with a lag
 Contractual restrictions expose more risk
 Agency problem inside
 Arbitrageurs are risk-averse
So the efficiency of arbitrage will be limited.
III. Discussion of Performance-based Arbitrage

 PBA supposes that all arbitrageurs have the

same sensitivity, and will invest all funds when
asset mispriced.
 In reality, they differ. resources indepen-dent
and invest more when price diverge further;
not need to liquidate.
 Big shock need more to eliminate, if not,
mispricing gets deeper.
 Little fresh capital available to stabilize.
So PBA is likely to be important .
IV. Empirical Implications

 A. Which markets attract arbitrage reso-

urces?
large funds concentrated in a few
markets, bond markets & foreign exch-
ange market;
the ability to ascertain value;
specialized arbitrageurs avoid volatile;
short horizons may be more relevant
IV. Empirical Implications

 B. Anomalies
• higher historical returns.
• EMH: compensation for higher risk impl-
ausible: large number of diversified
arbitrageurs.
• few specialized arbitrageurs care about
total risk fundamental or idiosyncratic.
• failing to recognize price-revisal .
IV. Empirical Implications

• In extreme circumstances, lose enough

money and liquidate;
• Investors become knowledgeable about
the strategies, diminish withdrawals; but
it will be slowly for investors take action.
V. Conclusion

 PBA may not be fully effective in

bringing prices to fundamental values;
 Specialized professional arbitrageurs
may avoid extremely volatility;
 The avoidance suggests a different
approach to understanding persistent
excess returns.
Thank you !