Location via proxy:   [ UP ]  
[Report a bug]   [Manage cookies]                
Scribd Logo
Upload

Welcome to Scribd!

  • 41 views

    Behavioral Finance Lecture 2

    Uploaded by

    Bas Kelder
    The document summarizes key points from a lecture on the limits of arbitrage. It discusses an example of a "pick-a-number game" and how rational investors cannot fully eliminate irrational pricing. It then profiles the hedge fund AQR Capital Management and one of its strategies called "betting against beta" that aims to exploit mispricings. The lecture also examines the costs and risks that arbitrageurs face, such as fundamental risk, noise-trader risk, and synchronization risk. An example is provided of the Royal Dutch and Shell shares that traded at inconsistent prices for years despite arbitrage attempts.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd

    Behavioral Finance Lecture 2

    Uploaded by

    Bas Kelder
    41 views12 pages
    The document summarizes key points from a lecture on the limits of arbitrage. It discusses an example of a "pick-a-number game" and how rational investors cannot fully eliminate irrational pricing. It then profiles the hedge fund AQR Capital Management and one of its strategies called "betting against beta" that aims to exploit mispricings. The lecture also examines the costs and risks that arbitrageurs face, such as fundamental risk, noise-trader risk, and synchronization risk. An example is provided of the Royal Dutch and Shell shares that traded at inconsistent prices for years despite arbitrage attempts.

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF, TXT or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    The document summarizes key points from a lecture on the limits of arbitrage. It discusses an example of a "pick-a-number game" and how rational investors cannot fully eliminate irrational pricing. It then profiles the hedge fund AQR Capital Management and one of its strategies called "betting against beta" that aims to exploit mispricings. The lecture also examines the costs and risks that arbitrageurs face, such as fundamental risk, noise-trader risk, and synchronization risk. An example is provided of the Royal Dutch and Shell shares that traded at inconsistent prices for years despite arbitrage attempts.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    41 views12 pages

    Behavioral Finance Lecture 2

    Uploaded by

    Bas Kelder
    The document summarizes key points from a lecture on the limits of arbitrage. It discusses an example of a "pick-a-number game" and how rational investors cannot fully eliminate irrational pricing. It then profiles the hedge fund AQR Capital Management and one of its strategies called "betting against beta" that aims to exploit mispricings. The lecture also examines the costs and risks that arbitrageurs face, such as fundamental risk, noise-trader risk, and synchronization risk. An example is provided of the Royal Dutch and Shell shares that traded at inconsistent prices for years despite arbitrage attempts.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    You are on page 1of 12

    BMME115 Behavioral Finance

    Lecture 2

    The Limits of Arbitrage

    Dr. Li He
    Rotterdam School of Management

    MScFI program
    Limit to Arbitrage References

    Pick-a-Number Game

    I Imagine yourself in a contest, where you are to choose a whole


    number between 0 and 100 as your entry.
    I The winner will be the person whose choice comes closest to
    two-thirds of the average entry.
    What number would you enter?

    Dr. Li He The Limits of Arbitrage 1 / 10


    Limit to Arbitrage References

    The Arbitrage Critique

    I Irrational investors cannot have a substantial, long-lived impact


    on prices.
    I Rational investors, or “arbitrageurs,” who trade aggressively
    against the mispricing, causing it to disappear.

    Dr. Li He The Limits of Arbitrage 2 / 10


    Limit to Arbitrage References

    In Practice: AQR Capital Management

    AQR Capital Management

    I It is the 2nd largest hedge fund in the US 2018 ranked by assets under
    management ($203 billion in 2019);
    I It has deep roots in academia: 45% of the AQR’s employees have earned
    advanced degrees, with 80 holding PhDs.

    Dr. Li He The Limits of Arbitrage 3 / 10


    Limit to Arbitrage References

    In Practice: AQR Capital Management

    Betting Against Beta [Frazzini and Pedersen, 2014]

    I Strategy Betting against beta (BAB) factor: hold low-beta assets, and
    short high-beta assets.
    I Theory Many investors are constrained in the leverage that they can take,
    and they therefore overweight risky securities instead of using leverage.
    I Empirics The BAB factor has highly significant risk-adjusted returns,
    accounting for its realized exposure to market, value, size, momentum, and
    liquidity factors (i.e., significant one-, three-, four-, and five-factor alphas).

    Dr. Li He The Limits of Arbitrage 4 / 10


    Limit to Arbitrage References

    In Practice: AQR Capital Management

    Source: Novy-Marx and Velikov (2018).


    The figure shows the performance of BAB with and without transaction costs. The sample covers January 1968
    through December 2017.

    Dr. Li He The Limits of Arbitrage 5 / 10


    Limit to Arbitrage References

    Costs and Risks of Arbitrage (1/2)

    I Fundamental risk Arbitrageurs may identify a mispricing of a


    security that does not have a close substitute that enables
    riskless arbitrage.
    I Noise-trader risk Once a position is taken, noise traders may
    drive prices further from fundamental value, and arbitrageurs
    may be forced to invest additional capital, which may not be
    available, forcing an early liquidation of the position.

    Dr. Li He The Limits of Arbitrage 6 / 10


    Limit to Arbitrage References

    Costs and Risks of Arbitrage (2/2)

    I Synchronization risk An arbitrageur who detects the


    overvaluation may be reluctant to trade against it because he
    does not know how many other hedge funds are aware of the
    mispricing.
    I Implementation costs Arbitrageurs face transaction costs and
    the cost of discovering a mispricing.

    Dr. Li He The Limits of Arbitrage 7 / 10


    Limit to Arbitrage References

    An Illustrative Example

    Twin Shares: Royal Dutch and Shell in 1907

    I Royal Dutch and Shell are independently incorporated in the Netherlands


    and England, respectively;
    I The structure has grown “out of a 1907 alliance” between Royal Dutch and
    Shell Transport by which the two companies agreed to merge their interests
    on a 60:40 basis while remaining separate and distinct entities (Royal
    Dutch 20 F, 1994, p. 1);

    Dr. Li He The Limits of Arbitrage 8 / 10


    Limit to Arbitrage References

    An Illustrative Example

    Twin Shares: Royal Dutch and Shell in 1907

    Source: Froot and Dabora [1999].


    This figure shows on a percentage basis the deviations from theoretical parity of Royal Dutch and Shell shares and
    ADRs traded on the NYSE. Data are from the Center for Research in Security Pricing (CRSP).

    Dr. Li He The Limits of Arbitrage 9 / 10


    Limit to Arbitrage References

    An Illustrative Example

    Twin Shares: Royal Dutch and Shell in 1907

    Knowing that:
    I Several hedge funds, Long-Term Capital Management included, did try to
    exploit this phenomenon;
    I Shorting shares of either company was an easy matter.

    Why might arbitrage be limited?

    Dr. Li He The Limits of Arbitrage 10 / 10


    Limit to Arbitrage References

    Reference I

    Frazzini, A. and Pedersen, L. (2014). Betting against beta. Journal of


    Financial Economics, 111(1):1–25.
    Froot, K. A. and Dabora, E. M. (1999). How are stock prices affected by the
    location of trade? Journal of Financial Economics, 53(2):189–216.

    Dr. Li He The Limits of Arbitrage 11 / 10

    You might also like