John Maynard Keynes was a observer of financial markets, and a successful investor in his own right. His investing success, however, was uneven, and

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Morris Clark
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2 John Maynard Keynes was a observer of financial markets, and a successful investor in his own right. His investing success, however, was uneven, and at one point he was reportedly wiped out while speculating on leveraged currencies. This perhaps led him to make the famous statement: Markets can remain irrational a lot longer than you and I can remain solvent.

3 Fundamental Risk. Arbitrageurs may identify a mispricing of a security that does not have a close substitute that enables riskless arbitrage. If a piece of bad news affects the substitute security involved in hedging, the arbitrageur may be subject to unanticipated losses. Noise Trader Risk. Noise traders limit arbitrage. Once a position is taken, noise traders may drive prices farther from fundamental value, and the arbitrageur may be forced to invest additional capital, which may not be available, forcing an early liquidation of the position.

4 A good example is the 2011 bankruptcy of MF Global. MF Global was fundamentally pursuing an arbitrage trade. The firm bought discounted European bonds (that were guaranteed by the European Stability Facility), and then used them as collateral for new loans, which they used to buy yet more bonds. So the bonds were guaranteed, and MF Global only had to repay the loans when the bonds matured at par in an amount greater that what was owed. It was the perfect arbitrage trade! The ultimate outcome, however, clearly demonstrates the limits to arbitrage: noisy traders pushed bond spreads wider, and MF Global got hit with a margin call that bankrupted the firm.

5 Implementation Costs. Short selling is often used in the arbitrage process, although it can be expensive due to the short rebate, representing the costs to borrow the stock to be sold short. In some cases, such borrowing costs may exceed potential profits. If short rebate fees are 10% or 20%, then arbitrage profits must exceed these costs to achieve profitability.

6 Risk and Cost: Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital, and is typically risky.

7 Noise Traders A noise trader is a stock trader that does not have any specific information of the security and their activity in the market causes equity prices to deviate from their true values. Someone whose trades are not based on information or financially meaningful analysis. Noise traders could act together to worsen a mispricing. Noise trader risk is important because the worsening of a mis-pricing could force the arbitrageur to liquidate early. irrational noise traders with erroneous beliefs both affect prices and earn higher expected returns This is also called DeLong, Shleifer, Summers, Waldmann Model

8 Noise Trading The main findings were: Noise traders cause asset prices to deviate from fundamentals, if risk-averse arbitrageurs have short trading horizons. Large price pressure in both stock and bond markets. Abnormal turnover occurs for large stocks and long-term bonds. Excessive volatility is associated with heavy price pressure. The survival of noise traders in financial markets: limits to arbitrage prevent rational traders from driving noisetraders out of the market

DEPARTMENT OF ECONOMICS Fall 2013 D. Romer

UNIVERSITY OF CALIFORNIA Economics 202A DEPARTMENT OF ECONOMICS Fall 203 D. Romer FORCES LIMITING THE EXTENT TO WHICH SOPHISTICATED INVESTORS ARE WILLING TO MAKE TRADES THAT MOVE ASSET PRICES BACK TOWARD