Limits of Arbitrage

Limits of Arbitrage

Limits of ArbitrageMayank JoshipuraTheory Supporting Limits to ArbitrageFundamental Risk Negative Shock and no Perfect Substitute (e.g. Ford and GM)Noise Trader Risk Continued Widespread IrrationalityForced Liquidation (Separation of Brains and Capital)Horizon Risk timing riskTrading in the Same Direction

Fundamental Risk: http://www.alphaarchitect.com/blog/2014/05/20/introduction-behavioral-finance-part-2-limits-arbitrage/#.VOOOrS4nIu82Cont..Implementation CostsCommissionBid/Ask SpreadPrice ImpactShort Sell CostsFeesVolume ConstraintsLegal RestraintsIdentification CostMispricing > PredictabilityEvidence Supporting Limits to ArbitrageMispricings Hard to IdentifyTest of Mispricing => Test of Discount Rate ModelTwin SharesRoyal Dutch (60%) and Shell (40%)Only Risk is Noise Traders=> PriceRD = 1.5*PriceS

Cont.Index InclusionsStock Price Jumps Permanently3.5% AverageFundamental RiskPoor Substitutes (best R2 < 0.25)Noise Trader RiskIndex Fund Purchases etc.Cont.Internet Carve-Outs3Com Sells 5% of Palm in IPO, Will Spin Off Remainder in 9 Months1 Share of 3Com will own 1.5 Shares of PalmPPalm = $953Com should be $142P3Com = $81Value of 3Com Excluding Palm = -$60Cont..Internet Carve-Outs3Com Sells 5% of Palm in IPO, Will Spin Off Remainder in 9 Months1 Share of 3Com will own 1.5 Shares of PalmPPalm = $953Com should be $142P3Com = $81Value of 3Com Excluding Palm = -$60

Cont..Why?Very Few Shares of Palm available to ShortArbitrage was LimitedMispricing Persisted