Limits to Arbitrage Slides

Question 1

Efficient Market Hypothisis

Answer 1

Price is equal to fundamental value
No free lunch

Question 2

When is there arbitrage opportunities

Answer 2

If either one of the principles of the EMH are violated then there is a chance to arbitrage. behavioral finance says price is usually not equal to fundamental value but there can be free lunch.

Question 3

How do behavioral finance models differ from traditional frameworks?

Answer 3

Departs from the idea that investors are by nature rational (bayes rule) and it is more realistic psychologically as humans can misprice assets below their realistic value.

Question 4

What is a critique of arbitrage?

Answer 4

• Irrational behavior does not impact the market prices
  -fundamental value is the price that reflects all available information
  -rational traders buy assets below FV and sell overpriced assets above FV

Question 5

Implementation Costs

Answer 5

Transaction costs, bid-ask spreads, and short selling costs

Question 6

Noise Trader Risk

Answer 6

-The mispricing may change in the short run forcing the arbitrager to close out their position at a loss
-Important as they use others $ in a hedge fund and investors may pull funds

Question 7

Fundamental Risk

Answer 7

• You know FV>price so you purchase the stock
  -Adverse news changes the value of the stock while you are holding it leading to the FV dropping below the MV
• To limit arbitrage the risk needs to be non-diversifiable (hedge the risk of an airline company’s stock with an oil price swing that will affect the price of your major position) difficult to diversify idiosyncratic risk

Question 8

Horizon Risk

Answer 8

Risk that mispricing takes so long that they end up earning less than the risk free rate. Irrational investors take a long time to revise mistaken beliefs and other arbitrageurs are too slow to hear about the mispricing.

Question 9

Model Risk

Answer 9

What if you incorrectly priced the FV of the asset? Then you are trading on an incorrect assumption.

Question 10

Twin Shares

Answer 10

Shares that have claim to the same cash flows. An example is royal dutch and shell which in 1907 merged. They have a 60/40 split which gives an obvious arbitrage opportunity if there is a mispricing

Question 11

Kelley Criterion

Answer 11

For bankroll management and position sizing
% bankroll is equal to expected winnings/net winnings (if won)