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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 10 / 23

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A SURVEY OF BEHAVIORAL FINANCE

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Figure 1.1. Log deviations from Royal Dutch/Shell parity. Source: Froot and Dabora (1999).

relatively undervalued share and short the other. Table 1.1 summarizes the risks facing the arbitrageur. Since one share is a good substitute for the other, fundamental risk is nicely hedged: news about fundamentals should affect the two shares equally, leaving the arbitrageur immune. Nor are there any major implementation costs to speak of: shorting shares of either com- pany is an easy matter.

The one risk that remains is noise trader risk. Whatever investor senti- ment is causing one share to be undervalued relative to the other could also cause that share to become even more undervalued in the short term. The graph shows that this danger is very real: an arbitrageur buying a 10 per- cent undervalued Royal Dutch share in March 1983 would have seen it drop still further in value over the next six months. As discussed earlier,

Table 1.1 Arbitrage Costs and Risks That Arise in Exploiting Mispricing

Fundamental

Noise Trader

Implementation

Example

Risk (FR)

Risk (NTR)

Costs (IC)

Royal Dutch/Shell

Index Inclusions

Palm/3Com

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