Monday, 26 May 2008

Arbitrage snippet

This paper (PDF) is a useful basic intro to behavioural economics, and has a nice short bit on abritrage. I never get tired of reading this kind of stuff:

[E]conomists now realize that even in financial markets there are important limits to the workings of arbitrage. First, in the face of irrational traders, the arbitrageur may privately benefit more from trading that helps push prices in the wrong direction than from trading that pushes prices in the right direction. Put another way, it may often pay “smart money” to follow “dumb money” rather than to lean against it (Haltiwanger and Waldman, 1985; Russell and Thaler 1985). For example, an extremely smart arbitrageur near the beginning of the tulip mania would have profited more from buying tulips and further destabilizing prices than by shorting them. Second, and slightly related, arbitrage is inherently risky activity and consequently the supply of arbitrage will be inherently limited (De Long, Shleifer, Summers and Waldman, 1990). Arbitrageurs who did decide to short tulips early would probably have been wiped out by the time their bets were proven to be “right”. Add to this the fact that in practice most arbitrageurs are managing other people’s money and, therefore judged periodically, and one sees the short horizons that an arbitrageur will be forced to take on. This point was made forcefully by Shleifer and Vishny (1997) who essentially foresaw the scenario that ended up closing Long Term Capital Management.

One could also point to Tony Dye (then at PDFM) as someone who didn't have time to be proven right.


Nick Drew said...

true arbitrage is risk-free - the simultaneous execution of two concurrently available and mutually mispriced deals. Such opportunities do indeed sometimes (fleetingly) present themsleves, and exploitation thereof is a valuable process leading to market efficiency - starting at the margin (a single arb) and rapidly benefitting the entire market

'arbitrage' between today's price and what you deem to be tomorrow's price is a purely speculative play - inherently risky, (sometimes profitable, of course)

the use of the term 'arbitrageur' in the passage you cite is an inaccurate one and runs the real risk of obscuring an important principle

Tom P said...

Fair point. Noted!