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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 8 / 23





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be diversified by taking many such positions. Condition (1) ensures that the mispricing will not be wiped out by a single arbitrageur taking a large posi- tion in the mispriced security. Condition (2) ensures that the mispricing will not be wiped out by a large number of investors each adding a small position in the mispriced security to their current holdings. The presence of noise trader risk or implementation costs will only limit arbitrage further.

Even if a perfect substitute does exist, arbitrage can still be limited. The ex- istence of the substitute security immunizes the arbitrageur from fundamen- tal risk. We can go further and assume that there are no implementation costs, so that only noise trader risk remains. De Long et al. (1990a) show that noise trader risk is powerful enough, that even with this single form of risk, arbitrage can sometimes be limited. The sufficient conditions are similar to those above, with one important difference. Here arbitrage will be limited if: (1) arbitrageurs are risk averse and have short horizons and (2) the noise trader risk is systematic. As before, condition (1) ensures that the mispricing cannot be wiped out by a single, large arbitrageur, while condition (2) pre- vents a large number of small investors from exploiting the mispricing. The central contribution of Shleifer and Vishny (1997) is to point out the real- world relevance of condition (1): the possibility of an early, forced liquida- tion means that many arbitrageurs effectively have short horizons.

In the presence of certain implementation costs, condition (2) may not even be necessary. If it is costly to learn about a mispricing, or the resources required to exploit it are expensive, that may be enough to explain why a large number of different individuals do not intervene in an attempt to cor- rect the mispricing.

It is also important to note that for particular types of noise trading, ar- bitrageurs may prefer to trade in the same direction as the noise traders, thereby exacerbating the mispricing, rather than against them. For exam- ple, De Long et al. (1990b) consider an economy with positive feedback traders, who buy more of an asset this period if it performed well last pe- riod. If these noise traders push an asset’s price above fundamental value, arbitrageurs do not sell or short the asset. Rather, they buy it, knowing that the earlier price rise will attract more feedback traders next period, leading to still higher prices, at which point the arbitrageurs can exit at a profit.

So far, we have argued that it is not easy for arbitrageurs like hedge funds to exploit market inefficiencies. However, hedge funds are not the only market participants trying to take advantage of noise traders: firm man- agers also play this game. If a manager believes that investors are overvalu- ing his firm’s shares, he can benefit the firm’s existing shareholders by issuing extra shares at attractive prices. The extra supply this generates could potentially push prices back to fundamental value.

Unfortunately, this game entails risks and costs for managers, just as it does for hedge funds. Issuing shares is an expensive process, both in terms of underwriting fees and time spent by company management. Moreover,

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