ISSN 0956-8549-650 Limits of Arbitrage: The State of the Theory
By
Denis Gromb
Dimitri Vayanos
THE PAUL WOOLLEY CENTRE
WORKING PAPER SERIES NO 9
DISCUSSION PAPER NO 650
DISCUSSION PAPER SERIES
March 2010
Denis Gromb is Professor of Finance at INSEAD, where he teaches Corporate Finance. He graduated from the Ecole Polytechnique, Paris, where he also obtained a PhD in Economics in 1994 while being a visiting student at the London School of Economics. His principal rearch interests include Corporat
e Finance, Corporate Governance, Banking, Limited Arbitrage and the Economics of Organizations. His articles have been published in leading academic journals in Economics and Finance. He has previously been on the faculty at MIT’s Sloan School of Management (1995-2001) and London Business School (2001-2008) and visited the London School of Economics (2007-2008). He has also taught doctoral level cours at a variety of institutions. Dimitri Vayanos is Professor of Finance at the London School of Economics. He received his undergraduate degree from Ecole Polytechique in Paris and his PhD from MIT in 1993. Prior to joining the LSE, he was faculty member at Stanford and MIT. Vayanos has published in a number of leading economics and finance journals on topics such as: liquidity and ast pricing, limited arbitrage, delegated portfolio management, information in markets and organizations, market microstructure, and behavioural economics. He is the Director of LSE’s Paul Woolley Centre for the Study of Capital Market Dysfunctionality, the Director of the CEPR Financial Economics program, and a Rearch Associate at NBER. Any opinions expresd here are tho of the authors and not necessarily tho of the FMG. The rearch findings reported in this paper are the result of the independent rearch of the authors and do not necessarily reflect the views of the LSE.
Limits of Arbitrage:The State of the Theory
Denis Gromb∗INSEAD and CEPR
捷的组词Dimitri Vayanos†
LSE,CEPR and NBER March8,2010‡
Abstract
We survey theoretical developments in the literature on the limits of arbitrage.This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and
providing liquidity to other investors.Rearch in this area is currently evolving into a broader
agenda emphasizing the role offinancial institutions and agency frictions for ast prices.This
rearch has the potential to explain so-called“market anomalies”and inform welfare and
policy debates about ast markets.We begin with examples of demand shocks that generate
mispricings,arguing that they can stem from behavioral or from institutional considerations.
We next survey,and nest within a simple model,the following costs faced by arbitrageurs:(i)
周星驰007risk,both fundamental and non-fundamental,(ii)short-lling costs,(iii)leverage and margin
constraints,and(iv)constraints on equity capital.Wefinally discuss implications for welfare
and policy,and suggest directions for future rearch.
Keywords:limits of arbitrage,market anomalies,liquidity,financial constraints,financial institutions,survey
打折促销
∗b@inad.edu
†d.vayanos@l.ac.uk
‡Article prepared for the Second Volume of the Annual Review of Financial Economics.We thank Suleyman Basak,Bruno Biais,Bernard Dumas,Vincent Fardeau,Robin Greenwood,Harald Hau,Peter Kondor,Arvind Kr-ishnamurthy,Anna Pavlova,Christopher Polk,Ana-Maria Santacreu,Yuki Sato and Pierre-Olivier Weill for helpful comments,and the Paul Woolley Centre at the LSE forfinancial support.
1INTRODUCTION
Standard models of ast pricing assume a reprentative agent who participates in all markets costlessly.Equilibrium prices in the models are tied to the reprentative agent’s consumption, which coincides with the aggregate consumption in the economy.The relationship between prices and consumption is summarized in the consumption CAPM,according to which an ast’s expected return in excess of the riskfree rate is proportional to the ast’s covariance with aggregate con-sumption.Intuitively,asts that correlate positively with consumption add to the risk borne by the reprentative agent and must offer high expected return as compensation.
The relationship between risk and expected return predicted by standard models appears to be at odds with a number of stylized facts commonly referred to as market anomalies.Leading anomalies include(i)short-run momentum,the tendency of an ast’s recent performance to con-tinue into the near future,(ii)long-run reversal,the tendency of performance over a longer history to revert,(iii)the value effect,the tendency of an ast’s ratio of price to accounting measures of value to predict negatively future returns,(iv)the high volatility of ast prices relative to mea-sures of discounted future payoffstreams,and(v)post-earnings-announcement drift,the tendency of stocks’earning surpris to predict positively future returns.1Reconciling the anomalies with standard models requires explaining variation in ast risk:for example,in the ca of short-run momentum,one would
have to explain why good recent performance renders an ast riskier and more positively correlated with aggregate consumption.A recent literature pursues explanations along the lines by introducing more general utility functions for the reprentative agent.Yet, reconciling standard models with all the anomalies,and in a way consistent with their quantitative magnitude remains elusive.
The anomalies listed above concern the predictability of ast returns bad on past prices and earnings.An additional t of anomalies concern the relative prices of asts with cloly related payoffs.For example,(i)“Siame-twin”stocks,with claims to almost identical dividend streams, can trade at significantly different prices,(ii)stocks of a parent and a subsidiary company can trade at prices under which the remainder of the parent company’s asts has negative value,and(iii) newly issued“on-the-run”bonds can trade at significantly higher prices than older“off-the-run”bonds with almost identical payoffs.2Anomalies concerning relative prices have been documented 1See,for example,Jegadeesh&Titman(1993)for evidence on short-run momentum,DeBondt&Thaler(1985) for long-run reversal,Fama&French(1992)for the value effect,LeRoy&Porter(1981)&Shiller(1981)for excess volatility,and Bernard&Thomas(1989)for post-earnings-announcement drift.See also the surveys by Fama(1991) and Schwert(2003).
中国人民大学分数线
2See,for example,Ronthal&Young(1990)and Dabora&Froot(1999)for evidence on Siame-twin stocks,
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for a more limited t of asts,partly becau of the scarcity of ast pairs with cloly related payoffs.At the same time,the anomalies are particularly hard to reconcile with standard models. Indeed,while standard models may offer slightly different predictions as to how risk and expected returns are related,they all imply the law of one ,asts with identical payoffs must trade at the same price.In the previous examples,however,differences in payoffs appear to be insignificant relative to the obrved price differences.
流连忘返什么意思Understanding why anomalies exist and are not eliminated requires a careful study of the process of arbitrage:who are the arbitrageurs,what are the constraints and limitations they face, and why arbitrage can fail to bring prices clo to the fundamental values implied by standard models.This is the focus of a recent literature on the limits of arbitrage.This article surveys important theoretical developments in that literature,nests them within a simple model,and suggests directions for future rearch.
Limits of arbitrage are commonly viewed as one of two building blocks needed to explain anoma-lies.The other building block are demand shocks experienced by investors other than arbitrageurs. Anomalies are commonly interpreted as arising becau demand shocks push prices away from fun-damental values and arbitrageurs are unable to correct the discrepancies.Such“non-fundamental”shocks to demand are often attributed to investor irrationality.In this n,rearch on the lim-its of arbitrage is part of the behavioralfinance agenda to explain anomalies bad on investors’psychological bias.3
This article departs from the conventional view in two related respects.First,it argues that rearch on the limits of arbitrage is relevant not only for behavioral explanations of anomalies but also for the broader study of ast pricing.Indeed,psychological bias are not the only source of non-fundamental demand shocks:such shocks can also ari becau of institutional frictions relating to contracting and agency,as the examples in the next ction show.Rearch on the limits of arbitrage characterizes how non-fundamental demand shocks,whether behavioral or not, impact prices.
犀角杯According to the conventional view,non-fundamental demand shocks concern investors other than arbitrageurs,and therefore can be understood independently of the limits of arbitrage.Our cond departure is to argue that many non-fundamental demand shocks can be understood jointly with limit
s of arbitrage within a tting that emphasizesfinancial institutions and agency.Indeed, Mitchell et al.(2002)and Lamont&Thaler(2003)for the relative pricing of parent and subsidiary companies,and Amihud&Mendelson(1991),Warga(1992)and Krishnamurthy(2002)for the on-the-run phenomenon.
苹果手机使用3Behavioral explanations for the anomalies include Barberis et al.(1998),Daniel et al.(1998),Hong&Stein (1999)and Barberis&Shleifer(2003).See also the survey by Barberis&Thaler(2003).
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arbitrage is often performed by specialized institutions such as hedge funds and investment banks, and the trading strategies of the institutions are constrained by agency frictions.At the same time,financial institutions and agency frictions are the source of many non-fundamental demand shocks.In this n,financial institutions do not necessarily correct anomalies,but can also cau them.Rearch on the limits of arbitrage is currently evolving into a broader agenda emphasizing the role offinancial institutions and agency frictions for ast prices.This agenda has the potential to offer a unified explanation of many anomalies.
The emphasis onfinancial institutions and agency frictions is fruitful for the analysis of welfare and pu
blic policy.Cris,including the recent one,show that government intervention can be important for the smooth functioning offinancial markets.In standard models,however,there is no scope for such intervention becau the equilibrium is Pareto optimal.Rearch on the limits of arbitrage has the potential to deliver a more uful framework for designing and asssing public policy.Indeed,this rearch takes a two-tiered view offinancial markets:a core of sophisticated arbitrageurs trade against mispricings,and in doing so provide liquidity to a periphery of less sophisticated investors.Under this view,thefinancial health of arbitrageurs is crucial for the smooth functioning of markets and the provision of liquidity.Understanding howfinancial health is affected by arbitrageurs’trading decisions,and whether the decisions are socially optimal,can guide public policy.
呐喊的读后感
This article proceeds as follows.Section2prents examples of non-fundamental demand shocks,emphasizing that they often stem from institutional considerations.Section3surveys im-portant theoretical developments in the literature on the limits of arbitrage,and nests them within a simple model.It emphasizes the following costs faced by arbitrageurs:(i)risk,both fundamental and non-fundamental,(ii)costs of short-lling,(iii)leverage and margin constraints,and(iv)con-straints on equity capital.4While the are not the only costs faced by real-life arbitrageurs,they are among the
most important and have received significant attention in the literature.Besides examining the implications of each type of cost for ast price behavior,Section3sketches how the costs can be integrated into richer models that incorporate multiple asts and dynamics. Such models have the potential to address a variety of anomalies—both of the type concerning violations of the law of one price,and of the type concerning return predictability—and are the subject of a rapidly growing literature.Finally,Section4discuss implications for welfare and public policy.
4Risk is a cost when arbitrageurs are not fully diversified and bear a disproportionate share of the risk of arbitrage trades.Undiversification is related tofinancial constraints,which we treat parately.
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