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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 11 / 23





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when a mispriced security has a perfect substitute, arbitrage can still be lim- ited if (1) arbitrageurs are risk averse and have short horizons and (2) the noise trader risk is systematic, or the arbitrage requires specialized skills, or there are costs to learning about such opportunities. It is very plausible that both (1) and (2) are true, thereby explaining why the mispricing persisted for so long. It took until 2001 for the shares to finally sell at par.

This example also provides a nice illustration of the distinction between “prices are right” and “no free lunch” discussed in section 2.1. While prices in this case are clearly not right, there are no easy profits for the taking.

2.3.2. index inclusions

Every so often, one of the companies in the S&P 500 is taken out of the index because of a merger or bankruptcy, and is replaced by another firm. Two early studies of such index inclusions, Harris and Gurel (1986) and Shleifer (1986), document a remarkable fact: when a stock is added to the index, it jumps in price by an average of 3.5 percent, and much of this jump is permanent. In one dramatic illustration of this phenomenon, when Yahoo was added to the index, its shares jumped by 24 percent in a single day.

The fact that a stock jumps in value upon inclusion is once again clear evidence of mispricing: the price of the share changes even though its fun- damental value does not. Standard and Poor’s emphasizes that in selecting stocks for inclusion, they are simply trying to make their index representa- tive of the U.S. economy, not to convey any information about the level or riskiness of a firm’s future cash flows.6

This example of a deviation from fundamental value is also evidence of limited arbitrage. When one thinks about the risks involved in trying to ex- ploit the anomaly, its persistence becomes less surprising. An arbitrageur needs to short the included security and to buy as good a substitute security as he can. This entails considerable fundamental risk because individual stocks rarely have good substitutes. It also carries substantial noise trader risk: whatever caused the initial jump in price—in all likelihood, buying by S&P 500 index funds—may continue, and cause the price to rise still fur- ther in the short run; indeed, Yahoo went from $115 prior to its S&P inclu- sion announcement to $210 a month later.

Wurgler and Zhuravskaya (2002) provide additional support for the lim- ited arbitrage view of S&P 500 inclusions. They hypothesize that the jump

After the initial studies on index inclusions appeared, some researchers argued that the price increase might be rationally explained through information or liquidity effects. While such explanations cannot be completely ruled out, the case for mispricing was considerably strengthened by Kaul, Mehrotra, and Morck (2000). They consider the case of the TS300 index of Canadian equities, which in 1996 changed the weights of some of its component stocks to meet an innocuous regulatory requirement. The reweighting was accompanied by significant price effects. Since the affected stocks were already in the index at the time of the event, information and liquidity explanations for the price jumps are extremely implausible. 6

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