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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 7 / 23

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6

BARBERIS AND THALER

worsening of the mispricing makes the arbitrageur more cautious from the start.

Implementation Costs. Well-understood transaction costs such as commis- sions, bid–ask spreads and price impact can make it less attractive to exploit a mispricing. Since shorting is often essential to the arbitrage process, we also include short-sale constraints in the implementation costs category. These refer to anything that makes it less attractive to establish a short posi- tion than a long one. The simplest such constraint is the fee charged for bor- rowing a stock. In general these fees are small—D’Avolio (2002) finds that for most stocks, they range between 10 and 15 basis points—but they can be much larger; in some cases, arbitrageurs may not be able to find shares to borrow at any price. Other than the fees themselves, there can be legal con- straints: for a large fraction of money managers—many pension fund and mutual fund managers in particular—short-selling is simply not allowed.5

We also include in this category the cost of finding and learning about a mispricing, as well as the cost of the resources needed to exploit it (Merton 1987). Finding mispricing, in particular, can be a tricky matter. It was once thought that if noise traders influenced stock prices to any substantial de- gree, their actions would quickly show up in the form of predictability in returns. Shiller (1984) and Summers (1986) demonstrate that this argument is completely erroneous, with Shiller calling it “one of the most remarkable errors in the history of economic thought.” They show that even if noise trader demand is so strong as to cause a large and persistent mispricing, it may generate so little predictability in returns as to be virtually undetectable.

In contrast, then, to straightforward-sounding textbook arbitrage, real world arbitrage entails both costs and risks, which under some conditions will limit arbitrage and allow deviations from fundamental value to persist. To see what these conditions are, consider two cases.

Suppose first that the mispriced security does not have a close substitute. By definition then, the arbitrageur is exposed to fundamental risk. In this case, sufficient conditions for arbitrage to be limited are: (1) that arbitrageurs are risk averse and (2) that the fundamental risk is systematic, in that it cannot

The presence of per-period transaction costs like lending fees can expose arbitrageurs to another kind of risk, horizon risk, which is the risk that the mispricing takes so long to close that any profits are swamped by the accumulated transaction costs. This applies even when the arbitrageur is certain that no outside party will force him to liquidate early. Abreu and Brun- nermeier (2002) study a particular type of horizon risk, which they label synchronization risk. Suppose that the elimination of a mispricing requires the participation of a sufficiently large number of separate arbitrageurs. Then in the presence of per-period transaction costs, arbi- trageurs may hesitate to exploit the mispricing because they don’t know how many other arbi- trageurs have heard about the opportunity, and therefore how long they will have to wait before prices revert to correct values. 5

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