Question

2) Behavioral finance posits that market prices may deviate from fundamental values because of investor psychology and that mispricing can persist if rational arbitrageurs face substantial limits to arbitrage. In our class lecture on behavioral finance, we discussed three "limits to arbitrage”. Choose 2 of the 3 limits to arbitrage that we discussed and explain them.

Answer 1

Question:

Behavioural finance posits that market prices may deviate from fundamental values because of investor psychology and that mispricing can persist if rational arbitrageurs face substantial limits to arbitrage. In our class lecture on behavioural finance, we discussed three “limits to arbitrage”. Chose 2 of the 3 limits to arbitrage that we discussed and explain them.

Answer:

In the real financial market, arbitrage is limited by many factors, asset prices need to be correctly evaluated & the effects of market system and traders itself are all need to be considered. Main 3 limited factors can be summarized as follows.

1)Fundamental risk : Incurred in exploiting the apparent profit opportunity presumably will limit the activity of the traders.

2)Implementation costs : This can limit the ability of arbitrage activity to force prices to fair value.

3)Model risk :Mispricing may make a position a good bet,but it is still a risky one,which limits the extent to which it will be pursed.

Out of 3 limits to arbitrage we will explain bellow 2 limits as per question:

1)Fundamental risk :Take Ford’s share as example, its basic value is $20 per share. While the pessimistic noise investors pull the price to $15 per share. If the arbitragers buy in at $15, the most direct risk they will face will be that a negative news about the basic value of Ford shares will cause stock price to fall further and cause big loss. Certainly, the arbitragers have already fully aware of this risk, so they will sale other stock (for example the GM) to replace while buy in the Ford’s share. But the problem is a complete alternative stock tend to be rare, so it is impossible to completely eliminate the basis risk.

2)Model risk :The starting point of arbitrage is the discovery of arbitrage opportunities for mispriced securities. Investors must fully understand and can predict the basic factors affecting all arbitrage securities and its change. The price model is needed to consider those factors to accurate pricing securities. Then arbitragers can use models to guarantee the price and the basic value of the securities, and to decide whether or not to participate in arbitrage.

Conclusion: Although arbitrage in the financial markets is often inadequate, needs money and needs taking risks, but it still drives market to the direction of more efficient. Based on the in-depth research and analysis of the risks during the arbitrage process, the limited arbitrage theory provides a reasonable explanation for the long-term existence of the financial assets price deviation.