Week 6

Question 1

What is arbitrage?

Answer 1

Exploiting diff. in prices of 2 identical assets –> arbitrageur buys cheaper asset & sells more expensive asset –> 0 net future cash flows when mkt reaches eq –> riskless profit w no initial capital outlay.

Question 2

How does Wurgler & Zhuravskaya (2002) explain fundamental risk as a limit to arbitrage?

Answer 2

• Stocks found to generally not have perf subs (fundamental risk) –> cash flows of asset cannot be replicated exactly –> makes arbitrage much more risky as still exposed to firm-specific risks if buying imperf subs.
• Stocks w less perfect subs found to experience larger abnormal returns when included in S&P 500 index –> not related to fundamentals of firm, but reflects demand of firm’s shares generated by index funds –> arbitrageurs would want to sell this stock & buy its cheaper subs however face difficulties in fully correcting mispricing due to lack of suitable subs as limit to arb so overpricing persists.

Question 3

How does the ‘twin-securities’ example explain noise trader risk?

Answer 3

• Consider examples of ‘Twin-securities’ in which share price of Royal Dutch should be equal to 1.5 times share price of Shell according to their joint ownership structure.
• Over observed time period there was both +ve & -ve deviations from this expected 1.5 ratio.
• Cannot be explained by fundamental risk, since Royal Dutch & Shell are perfect subs w identical cash flows.
• Irrational noise traders trade based on irrelevant info not related to fundamentals.
• Although arbitrageurs would ordinarily seek to exploit the mispricing when prices deviate from this expected 1.5 ratio (reflecting fundamental values), they may become hesitant/risk-averse in face of unpredictable, erratic & volatile price movements caused by noise trading, limiting their willingness to take positions to correct mispricings – > may suffer losses in SR & difficulties w timing arb strategy as as they may have to liquidate before price recovers.

Question 4

How does Lamont & Thaler (2003) explain implementation costs as a limit to arbitrage?

Answer 4

• Palm was subsidiary company to 3Com –> 3Com sold fraction of its stake in Palm to general public but also announced remaining shares it owned would be distributed to 3Com shareholders in future –> 3Com shareholders would receive about 1.5 shares of Palm for every share of 3Com that they owned.
• Palm share price > 3Com share price.
• Arbitrageur should buy 100 shares of 3Com & sell short 150 shares of Palm to exploit opp –> however mispricing persisted indicating transaction costs in short-selling Palm –> had difficulty in timing arb strategy.
• No evidence of fundamental risk. or noise-trader risk (as rational investors expected apparent mispricing to be corrected around time when shares distributed).

Question 5

What are the 3 examples of limits to arbitrage?

Answer 5

1) Fundamental Risk - Wurgler & Zhuravskaya
2) Twin-securities
3) Implementation Costs - Lamont & Thaler