Limited Arbitrage

Question 1

critics of Behaviroual finance will argue that any effect an irrational investor might have on stock price behaviour will be eliminated by the activities of rational arbitrageurs. is this actually the case? support your argument with relevant literature

Answer 1

it is not always the case that the activities of rational arbitrageurs will eliminate the effects of irrational investors on stock price behaviours.

while it is true that rational arbitrageurs may attempt to profit from mispricings in the market by buying undervalued assets and selling over valued ones, there are several factors that can prevent them from being successful in correcting these mispricings.

one of the key challenges facing rational arbitrageurs is the potential for wide-spread Behaviroual biases among investors. for example, if a significant number of investors are prone to the same behavioural biases, such as overconfidence or herding, this may lead to potential mispricing in the market that makes it difficult for arbitrageurs to profit from. in such cases, the activities of rational arbitrageurs may not be sufficient enough to elimintae the effects of irrational investors on stock prices.

another challenge for rational arbitrageurs is the potential lack of information or liquify in the market. if there is a lack of information about the true value of an asset, or if there is lack of liquidity, it may be difficult for arbitrageurs to profit from mispricings, because they may not have access to the necessary information or may not be able to trade in large enough quantities to affect the price. in these cases, the activities of rational arbitrageurs may not be able to correct mispricing in the market.

in a paper by (Shleifer et al 1990) the authors examine the role of arbitrageurs in financial markets and argue that they may not always behave rationally.

the authors argue that arbitrageurs, like other investors, are subject to behavioural biases and cognitive errors that can affect their decision making. they also discuss how the presence of irrational arbitrageurs in the market can lead to mispricings that are difficult to correct, even if there are rational arbitrageurs present.

the paper suggests that arbitrageurs may not always be able to eliminate the effects of irrational investors on stock prices.

Horizon risk, as described by Dow and Gorton (1994), refers to the risk that arises when an investor attempts to profit from an arbitrage opportunity, but is unable to complete the trade before the opportunity disappears or the market conditions change. This can limit the ability of investors to profit from arbitrage opportunities, as they may be unable to execute their trades quickly enough to take advantage of the opportunity.

Noise trader risk, as described by DSSW (1990), Shleifer and Vishny (1997), and Lui and Longstaff (2004), refers to the risk that arises when the actions of market participants who are not behaving rationally, or “noise traders,” cause asset prices to deviate from their fundamental values. This can create arbitrage opportunities, but also makes it difficult for investors to profit from them, as the actions of noise traders can quickly eliminate the opportunities or create unexpected risks