Limits to arbitrage: Difference between revisions
imported>Voidxor m →Further reading: Templatize |
imported>Voidxor →Examples: Create section. Add refs. Verify claims. Copy edit for encyclopedic tone. Additional citations needed (and I've made it clear which sentences). Promote {{Unreferenced}} to {{More citations needed}}. #JUN25 |
||
| Line 1: | Line 1: | ||
{{ | {{More citations needed|date=June 2025}} | ||
'''Limits to arbitrage''' is a [[theory]] in [[financial economics]] that, due to restrictions that are placed on funds that would ordinarily be used by rational [[Stock trader|traders]] to [[arbitrage]] away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time. | '''Limits to arbitrage''' is a [[theory]] in [[financial economics]] that, due to restrictions that are placed on funds that would ordinarily be used by rational [[Stock trader|traders]] to [[arbitrage]] away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time. | ||
| Line 7: | Line 7: | ||
Rational traders usually work for professional [[Investment management|money management firms]], and [[Investment|invest]] other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency. | Rational traders usually work for professional [[Investment management|money management firms]], and [[Investment|invest]] other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency. | ||
In perhaps the best known example, the American firm [[Long-Term Capital Management]] (LTCM) fell victim to limits | ==Examples== | ||
In perhaps the best known example, the American firm [[Long-Term Capital Management]] (LTCM) fell victim to limits to arbitrage in August 1998.<ref name="Shleifer 2000 pp109–110">{{cite book |last=Shleifer |first=Andrei |date=2000 |title=Inefficient Markets: An Introduction to Behavioral Finance |series=Clarendon Lectures in Economics |publisher=Oxford University Press |isbn=9780198292289 |issn=1754-5811 |pages=109–110 }}</ref> The company was highly [[Leverage (finance)|leveraged]],<ref name="Shleifer 2000 pp109–110" /> and had staked its investments on the convergence of the prices of certain bonds in the long run.{{Citation needed|date=June 2025}} However, in the short run, due to the [[1997 Asian financial crisis]] and the [[1998 Russian financial crisis#Crisis and effects|Russian government's debt default]], panicked investors traded against LTCM's position, and the prices that had been expected to converge were, instead, driven further apart.{{Citation needed|date=June 2025}} This caused LTCM to face [[margin call]]s.{{Citation needed|date=June 2025}} Because the firm lacked the available funds to cover these calls, it was compelled to close out its positions and to take great losses.<ref name="Shleifer 2000 pp109–110" /> Due to the potential for a large [[Shock (economics)|shock]] should LTCM fail, the [[Federal Reserve Bank]] facilitated a [[bailout]].<ref name="Shleifer 2000 pp109–110" /> | |||
==See also== | ==See also== | ||
| Line 16: | Line 17: | ||
==Further reading== | ==Further reading== | ||
* {{cite | * {{cite journal |last1=Gromb |first1=Denis |last2=Vayanos |first2=Dimitri |date=2002 |title=Equilibrium and Welfare in Markets with Financially Constrained Arbitrageurs |journal=Journal of Financial Economics |volume=66 |pages=361–407 }} | ||
* {{cite journal |last1=Gromb |first1=Denis |last2=Vayanos |first2=Dimitri |date=2010 |title=Limits of Arbitrage: The State of the Theory |journal=Annual Review of Financial Economics }} | |||
* {{cite journal |last=Kondor |first=Peter |date=April 2009 |title=Risk in Dynamic Arbitrage: Price Effects of Convergence Trading |journal=Journal of Finance |volume=64 |issue=2 }} | |||
* {{cite journal |last1=Gromb |first1=Denis |first2=Dimitri | * {{cite journal |last1=Shleifer |first1=Andrei |last2=Vishny |first2=Robert W. |date=1997 |title=The Limits of Arbitrage |journal=The Journal of Finance |publisher=American Finance Association }} | ||
* {{cite journal |last=Kondor |first=Peter |title=Risk in Dynamic Arbitrage: Price Effects of Convergence Trading |journal=Journal of Finance |volume=64 |issue=2 |date= | * {{cite journal |last=Xiong |first=Wei |date=2001 |title=Convergence Trading with Wealth Effects |journal=Journal of Financial Economics |volume=62 |pages=247–292 }} | ||
* {{cite journal |last=Xiong |first=Wei |date=2001 |title=Convergence | |||
[[Category:Arbitrage]] | [[Category:Arbitrage]] | ||
[[Category:Financial economics]] | [[Category:Financial economics]] | ||
[[Category:Financial markets]] | [[Category:Financial markets]] | ||
Latest revision as of 15:52, 30 June 2025
Template:More citations needed
Limits to arbitrage is a theory in financial economics that, due to restrictions that are placed on funds that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time.
The efficient-market hypothesis assumes that whenever mispricing of a publicly traded stock occurs, an opportunity for low-risk profit is created for rational traders. The low-risk profit opportunity exists through the tool of arbitrage, which, briefly, is buying and selling differently priced items of the same value, and pocketing the difference. If a stock falls away from its equilibrium price (let us say it becomes undervalued) due to irrational trading (noise traders), rational investors will (in this case) take a long position while going short a proxy security, or another stock with similar characteristics.
Rational traders usually work for professional money management firms, and invest other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency.
Examples
In perhaps the best known example, the American firm Long-Term Capital Management (LTCM) fell victim to limits to arbitrage in August 1998.[1] The company was highly leveraged,[1] and had staked its investments on the convergence of the prices of certain bonds in the long run.Script error: No such module "Unsubst". However, in the short run, due to the 1997 Asian financial crisis and the Russian government's debt default, panicked investors traded against LTCM's position, and the prices that had been expected to converge were, instead, driven further apart.Script error: No such module "Unsubst". This caused LTCM to face margin calls.Script error: No such module "Unsubst". Because the firm lacked the available funds to cover these calls, it was compelled to close out its positions and to take great losses.[1] Due to the potential for a large shock should LTCM fail, the Federal Reserve Bank facilitated a bailout.[1]
See also
References
Further reading
- Script error: No such module "Citation/CS1".
- Script error: No such module "Citation/CS1".
- Script error: No such module "Citation/CS1".
- Script error: No such module "Citation/CS1".
- Script error: No such module "Citation/CS1".