Professional Arbitrage - Inefficent Markets (based on Shleifer)

Chapter 4: Professional Arbitrage

from the book

Shleifer: “Are markets efficient?”

Introduction 4.0. Basics 4.1. An agency model of limited arbitrage

4.2. Performance-based arbitrage and market efficiency 4.3. Discussion of performance – based arbitrage

4.4. Long Term Capital Management

Seminararbeit von:

Eigner Franz, a0301345, A140 bei Prof. Dorosel, UK Financial Markets, WS 05/06 Wien, Jänner 2006

UK Financial Markets Chapter 4: Professional Arbitrage Eigner Franz, WS 05/06

Seite 2 von 13 17.02.2007

Introduction:

Shleifer’s book „Inefficient Markets. An Introduction to Behavioural Finance?“ deals with the

problematic nature of the efficient markets theory. EMH, a main component of efficient

markets theory which was very popular in the 70’s, asserts that financial markets are efficient

and that prices on traded assets fully reflect the available information and therefore collective

beliefs of all investors about future prospects. It states that securities prices in financial

markets must equal fundamental values, either because all investors are rational or because

arbitrage eliminates pricing anomalies As a consequence, it is not possible to consistently

outperform the market by using public (known) information. This doesn’t require that all

investors behave rationally, but investors’ trades have to be random enough and not

predictable. If some behave irrationally, rational arbitrageurs will eliminate their influence on

prices. However in the 80’s and the 90’s, the EMH was challenged, on both the theoretical

and the empirical grounds. A new alternative theory was invented, behaviour finance, which

primarily says that “economic theory does not lead us to expect markets to be efficient.

Behavioural finance states, in contrast to the efficient markets theory, that “real world

arbitrage is risky and therefore limited1”. In this paper, chapter 4 of this book ‘Professional

Arbitrage’ will be treated in detail, which mainly shows by a model, based on agency

relationship, that arbitrages are limited and unstable and hence lead to inefficient markets.

4.0 Basics

The fundamental new feature in this chapter is agency relationship, which separates

knowledge and resources. In our new, more common model in reality, investors are

responsible for the resources and the arbitrageurs are in possession of specialized knowledge

in order to manage these resources. Before we dealt with arbitrageurs who used their own

wealth to trade and their investments were not limited by resources but only by risk aversion.

Now we deal with arbitrageurs, who manage the money they get from investors. Let us think

for instance of hedge funds, which take money from wealthy individuals, banks and other

investors and invest it profitably.

1 Limits to arbitrage is a theory which assumes that restrictions placed upon funds, that would ordinarily be used by rational traders to arbitrage away pricing inefficiencies, leave prices in a non-equilibrium state for protracted periods of time.


Seite 3 von 13 17.02.2007

A main point of this chapter is “Performance based arbitrage”, which is the “phenomenon of

responsiveness of funds under management2 to past returns.” Arbitrage requires capital,

which is invested by arbitrageurs. Investors have limited knowledge about the market. Hence,

when they have to allocate funds to the arbitrageurs, they can mainly focus their attention on

the past performance of their funds. If the prices for their funds are decreasing, they could

believe their arbitrageur is incompetent. As a result they may refuse giving him more money

or even withdraw some of the capital, giving it to other arbitrageurs in the same market.

The paradox in this situation is that when prices are falling, for instance when mispricing

widens, arbitrageurs have the best opportunities in making money. (because prices have to

increase to the fundamental value in the long term)

However, in fear, investors could lose their faith in them arbitrageurs will be less aggressive

in betting against mispricing.

It can be shown, that “this feature of arbitrage can limit its effectiveness in achieving market

efficiency, especially when prices are far away from fundamentals and investors are fully

invested.”

4.1 An Agency Model of Limited Arbitrage

Let us set up a simple model that shows us the mechanics of performance based arbitrage and

the agency relationship between arbitrageurs and their investors. In our market for a specific

asset, we have three types of participants. Noise traders3, arbitrageurs and investors in

arbitrage funds. Investors allocate funds between arbitrageurs, who are trading only in one

market whereas investors are active in other markets too. We have three time periods 1 , 2 and

3. The fundamental value of the asset is V, which is at first, only known to arbitrageurs and

not to investors. Finally at t3 the value of the asset is equal to the price of the asset which is

known by arbitrageurs and noise traders (V = p3). Hence there is no long run fundamental risk

in such a trade.

Noise traders are assumed to be pessimistic. In each period they may experience a pessimism

shock S.

2 Compare: Assets under management (AUM) is a term used by financial services companies in the mutual fund and money

management or investment management business to determine how much money they are managing. Many financial services companies use this as a measure of success and comparison against their competitors.

3 A noise trader is a stock trader that does not have any specific information of the security. If the efficient market hypothesis holds, noise traders add liquidity to a market while not distorting valuations. In fact, a market without noise traders will tend to break down, because prices in such a market will become fully revealing.


Seite 4 von 13 17.02.2007

The Aggregate noise traders’ demand for the asset is:

QN(t) = [V- St] / pt (4.1)

S1 is known to arbitrageurs, S2 is unknown; arbitrageurs and investors are fully rational;

If S2 > S1, noise trade misperceptions deepen before they correct at t = 3. We assume risk-

neutral arbitrageurs who take position against mispricing generated by noise traders.

Arbitrageurs have cumulative, but limited resources under management (which includes also

their borrowing capacity) given by F. F1 is exogenously given; F2 will be described later (As

opposed to the model from chapter 2, where arbitrageurs could invest as much as they

wanted).

If prices at time 2 recover to V, then arbitrageurs invest in cash. If not, arbitrageurs will invest

all of F2 in the underpriced asset, because it’s known that p rises to V at t = 3 for sure. In this

case, the arbitrageurs’ demand for the asset is: QA(2) = F2/p2

QN(2) + QA(2) = (V – S2 + F2) / p2

Since aggregate demand for the asset equals the unit supply, we get:

p2 = V - S2 + F2 (4.2)

assumptions:

F2 < S2, which means that “arbitrage resources are not sufficient to bring the period 2 price to

fundamental value, unless of course, noise traders misperceptions have corrected anyway.”,

and also F1 < S1.

In t1, arbitrageurs also want to keep some of the money in cash in case the asset becomes even

more underpriced at t = 2, in order to invest more in that asset.

It concludes: QA(1) = D1/p1

where D1 is the amount that arbitrageurs invests in the asset at t = 1

and p1 = V – S1 + D1 (4.3)

We now specify the relationship between arbitrageurs and their investors, which determines

F2. We are looking at a particular market segment and within such segments are many

arbitrageurs competing against each other. We assume that no arbitrageur can affect asset

prices, they all have the same marginal cost and each arbitrageur has at least on competitor,

who is a perfect substitute. Under these conditions, we can say: price = MC

Risk neutral investors allocate their $1 investment to maximize expected consumer surplus.

(expected return on dollar – price charged by the arbitrageur) Investors have prior beliefs

about the expected return of each arbitrageur and give his money to the arbitrageur with the

highest expected return. Investors have different beliefs, hence there is no arbitrageur who


Seite 5 von 13 17.02.2007

gets all the money. The market share of each arbitrageur is just the total fraction of investors,

who believes he is the best.

Investors update their beliefs about the future expected returns by looking at the past

performance because they neither know all the trading strategies of the arbitrageurs nor they

have specialized knowledge. Hence arbitrageurs who experience poor return in a given period

should lose market share to those with better returns.

We can now set up investors’ aggregate supply of funds to the arbitrageur at time 2. It’s an

increasing function of arbitrageurs’ gross return between time 1 and time 2, which bases on

Performance-based-arbitrage (PBA).

F2 = F1 * G[D1/F1) * (p2/p1) + (F1 - D1)/F1] (4.4)

where return on the asset = p2/p1 and with G(1) = 1, G´ ≥ 1, G´´≤ 0.

If arbitrageurs do an average job, they will neither gain nor lose funds under management. If

they outperform (underperform) the benchmark, they will gain (lose) funds. Investors try to

attribute an arbitrageurs performance to one of three causes: a random error, a deepening of

noise trader sentiment (bad luck) or (3) inferior ability.

Remark:

o “High variation in ability across arbitrageurs will tend to increase the responsiveness

of funds under management to past performance (G´).”

o “A high variance of the noise trader sentiment relative to the variation in ability will

generally decrease the responsiveness to past performance.”

Paradox: “Taking money away from an arbitrageur after noise trader sentiment deepens, i.e.

precisely when his expected return is the highest, is a rational response to the problem of

trying to infer the arbitrageur’s (unobserved) ability and future opportunities jointly from past

returns”.

We assume a linear G: G(x) = ax + 1 - a with a ≥ 1 (4.5)

where x is the arbitrageur’s gross return.

Funds under management for period 2 are:

F2 = a {D1(p2/p1) + (F1 – D1)} + (1-a) F1 = F1 – a D1 (1 - p2/p1) (4.6)

Remark:

o If p2 = p1, the arbitrageur earns a zero net return (he neither gains funds nor loses

funds under management.

o If p2 > p1, he gains funds, if p2 < p1, he loses funds.

o a: A higher a leads to more sensitive resources under management to past

performance. If a = 1, the arbitrageur doesn’t get any more money when he loses


Seite 6 von 13 17.02.2007

some money(but old funds are not withdrawn). If a > 1, funds are even withdrawn in

case of poor performance.

Problem of PBA:

”In conventional arbitrage, capital is allocated by arbitrageurs based on expected returns from

their trades.” But here, “under PBA, in contrast, capital is allocated based on past returns”,

which are low when expected returns are high. In this paradox situation, “arbitrageurs have to

face fund withdrawals and are not very effective in betting against the mispricing.” Hence

PBA is critical to our model. To avoid this problem, arbitrageurs could signal their abilities to

the investors by offering incentive contracts, where they insure investors against losses.

However these contracts in fact don’t eliminate the influence of past performance on the

market shares of arbitrageurs.”

Finally we have to set up the arbitrageur’s optimization problem.

We assume that the arbitrageur maximizes expected time 3 profits and under our assumptions

(all arbitrageurs are price takers and MC is constant) this is equivalent to maximizing

expected time 3 funds under management (the more funds, the more profit).

“We examine a specific form of uncertainty about S2. We assume that, with probability q

noise trader misperceptions deepen, so S2 = S > S1. With a complementary probability 1-q

noise traders recognize the true value of the asset at t = 2, so S2 = 0 and p2 = V.”

When S2 = 0, arbitrageurs liquidate their position at a gain at t = 2 and hold cash until t = 3

(because they can not earn money with the fund, V = p2 = p3)

Wd = a(D1*V/p1+ F1 – D1) + (1-a) * F1

When S2 = S, arbitrageur’s third period funds are given by

Wr = (V/p2) * [a {D1* p2/p1+ F1 – D1} + (1-a) * F1]

Arbitrageurs then maximize:

EW = (1-q) * Wd + q* Wr (4.7)

4.2 Performance-Based Arbitrage and Market Efficiency

3 benchmarks:

o In efficient markets, arbitrageurs can invest as much money as they want only limited

by their risk aversion, i.e. there is no capital limit. In this case, noise trader shocks can

be completely counteracted by arbitrageurs.


Seite 7 von 13 17.02.2007

o “Arbitrage resources are limited but PBA is inoperative, so arbitrageur can always

raise F1.” Even if they lose money, they can replenish their capital up to F1, (p1 = V -

S1 + F1 and p2 = V - S + F2). We see: prices fall exactly one by one with noise trader

shocks (p2 = V – S1 + F1 and P2 = V – S + F2).

o If a = 1, “arbitrageurs can not replenish the funds they have lost, but don’t

suffer from withdrawals beyond what they have lost.”

FOC to the arbitrageur’s optimization problem:

(1-q) * (V/p1 - 1) + q*(p2/p1 - 1) * V/p2 ≥ 0 (4.8)

The first term of (4.8) describes the “incremental benefit to arbitrageurs of an extra dollar of

investment if the market recovers at t = 2”, which means that noise trader recognize the true

value of the asset.

The second term describes the “incremental loss if the price falls at t = 2, before recovering at

t = 3, and so they have forgone the option of being able to invest more in that case.” (when p2

is small, arbitrageurs should invest, because p2 has to increase to V at sure the next period).

(4.8) holds with

o strict equality, if “arbitrageurs choose to hold back some funds for the option to invest

more at time 2”, in case the price deterioration is high and sure enough (D1 < F1).

o Strict inequality, if the first shock S1 is large and S is not too large relative to S1. For

this, q should be relative low, p1 low relative to V and p2 is not too low relative to p1,

i.e. prices should be expected to recover soon (D1 = F1). Under these circumstances,

arbitrageurs choose to be fully invested at t = 1 rather than hold spare reserves for the

next period. We call such situations, where mispricing is that high at t = 1 that

arbitrageurs want to be fully invested ‘extreme circumstances’.

I will describe the case with ‘extreme circumstances’ at some length.

Proposition 1:

For given V, S1, S, F1, a, there is a q* such that, for q > q*, D1 < F1, and for q < q*,

D1 = F1.

If (4.8) holds with equality, we can calculate equilibrium with (4.2) (4.3) (4.6) (4.8)

If (4.8) holds with inequality, we can calculate equilibrium with (4.2), (4.6) and with the

formulas D1 = F1, p1 = V – S1 + F1

Let V = 1, F1 = 0.2, a = 1.2, S1 = 0.3, S2 = 0.4


Seite 8 von 13 17.02.2007

We assume: q* = 0.35

o If q < 0.35, arbitrageurs are fully invested and D1 = F1 = 0.2, so p1 = 0.9

If noise trader sentiment deepens, we have F2 = 0.1639 and p2 = 0.7636

If noise trader sentiment recovers, we have F2 = 0.227 and p2 = V = 1

o If q > 0.35, arbitrageurs hold back some of the funds at time 1. Then p1 is lower than it

could be with full investment. We assume: q = 0.5; D1 = 0.1743 and p1 = 0.8743.

If noise trader sentiment deepens, then F2 = 0.1766 and p2 = 0.7766

If noise trader sentiment recovers, then F2 = 0.23 and V=1

This simple model shows us, that both equilibriums are plausible and that “the larger the

shocks are the further are the prices away from fundamental values.”

Proposition 2:

At the corner solution (D1 = F1), dp1/dS1 < 0, dp2/dS < 0 and dp1/dS = 0. At the

interior solution, dp1/dS1 < 0, dp2/dS < 0 and dp1/dS < 0

It says that “arbitrageurs’ ability to bear against mispricing is limited and larger noise trader

shocks lead to less efficient pricing.” When we have an interior solution, arbitrageurs are

holding more cash at t = 1 in order to spread the effect of a deeper period 2 and thus allowing

prices to fall more at t = 1. At t = 2, they have more funds in order to counter mispricing at

that period. “Here the reason for holding back is not risk aversion but rather the option to

invest more in the future if mispricing deepens.”

Proposition 3:

If arbitrageurs are fully invested at t = 1, and noise trader misperceptions deepen at t

= 2, then for a > 1 we have F2 < D1 and F2/p2 < D1/p1,

where F2 < D1 means arbitrageurs invest less total dollars in the asset at t = 2 than at t = 1 and

where F2/p2 < D1/p1 means that arbitrageurs actually hold less of the asset at t = 2 than at t = 1.

These are measurements for aggressiveness of arbitrageurs when mispricing worsens. “The

clearest case of less aggressive arbitrage at t = 2 would occur if arbitrageurs hold fewer shares

at t = 2, and are liquidating their holdings”, although prices have fallen from t = 1. This

proposition describes the extreme circumstances in our model, in which “fully invested

arbitrageurs experience an adverse price shock, face equity withdrawals and so liquidate their

holdings of the extremely underpriced asset. Arbitrageurs bail out of the market when

opportunities are the best”, i.e. when expected returns are high.


Seite 9 von 13 17.02.2007

For fully invested arbitrageurs, we get:

p2 = [V – S – aF1 + F1] / [1 – aF1/p1], (4.9)

where aF1 < p1, which is a simple stability condition that says “arbitrageurs don’t lose so much

money that they bail out of the market completely.” (Otherwise: p2 = V – S, at t = 2)

“In the stable equilibrium, arbitrageurs lose funds under management as prices fall and hence

liquidate some holdings, but they still stay in the market. “

Proposition 4:

At fully invested equilibrium, dp2/dS < -1 and d2p2 / (dS)

2 not< 0

“This proposition shows that when arbitrageurs are fully invested at time 1, prices fall more

than one for one with the noise trader shock at time 2.” “When prices are furthest from

fundamental values, arbitrageurs take the smallest positions.”

If PBA intensifies i.e. as a rises, “the price decline per unit increase in S gets greater”. A

market driven by PBA loses its resiliency4 in extreme circumstances,

It is shown that “arbitrage process can be quite ineffective in bringing prices back to

fundament values in extreme circumstances. “

In the model in chapter 2 arbitrageurs are more aggressive when prices are furthest away from

fundamental values. Hence the stabilizing effect will be larger in these cases. This is constant

with Friedman, who stated that on average arbitrageurs make money and move prices toward

fundamentals. However our new model shows “that the times when arbitrageurs lose money

are precisely the times when prices are far away from fundamentals”, and in those times the

trading by arbitrageurs has the weakest stabilizing effect.

Which markets do arbitrageurs prefer?

It depends mainly on their “ability to ascertain value with confidence and to realize it

quickly.” Arbitrageurs prefer markets like bond market and foreign exchange market, where

calculations of relative values are manageable. Here the risk of involuntary liquidations is

low; hence the fundamental risk in arbitrage is little. Also markets with extreme leverage5,

short selling, and performance based fees are common, whereas in stock markets, both “the

4 dp2/dS measure of the resiliency of the market equal to zero for an efficient market and to -1 when a = 0 and there is no PBA). 5 Financial leverage takes the form of borrowing money and reinvesting it with the hope to earn a greater rate of return than the cost of interest. Leverage allows greater potential return to the investor than otherwise would have been available. The potential for loss is greater because if the investment becomes worthless, not only is that money lost, but the loan still needs to be repaid.


Seite 10 von 13 17.02.2007

absolute and relative values of different securities are harder to calculate.” Arbitrage

opportunities are harder both to identify.

In addition, specialized arbitrageurs “might avoid extremely volatile markets”, in contrast to

the well - diversified arbitrageurs of Chapter 2. The probabilities of shocks are in these

markets much higher and this deters off the arbitrageurs, although such markets sometimes

offer better arbitrage opportunities. Specialized arbitrageurs can not diversify that much

because of their limited knowledge.

4.3 Discussion of Performance – Based Arbitrage

“PBA delinks the arbitrageurs’ demand for an asset from its expected return and is

consequently very limited.” In fact, PBA plays an important role in the world. Arbitrageurs

might be able to “hold out and not liquidate until the price recovers. “By diversification

arbitrageurs might be able to avoid losing all the money at the same time, but diversification

is restricted on account of their specialized knowledge. Experienced arbitrageurs with “long

and successful track records may be in a better position than inexperienced arbitrageurs in

order to avoid equity withdrawals. When funds under management decline, they do it with a

lag. However lags on fund withdrawals are in reality very short. For instance voluntary

liquidation shortens the lags. When risk averse arbitrageurs liquidate, because of the fear that

a possible further adverse price move can cause a dramatic outflow of funds later on, or a

forced liquidation by creditors.” As a result, the fear of future withdrawals worsens the

situation and has a similar effect as withdrawals themselves.”

“Perhaps the most important reason why poor performance leads to quick asset sales is

liquidation by creditors”, so called involuntary liquidation. “Creditors usually demand

immediate repayment or else liquidate the collateral6, when the value of this collateral gets

near the debt level.” “Unlike the equity investors7 in funds, who may […] wait to withdraw

their capital, creditors have every incentive to rush to get their money back ahead of the

equity.” “Arbitrageurs need to come up with cash to satisfy their creditors and avoid

liquidation precisely when they are fully invested and do not have any spare cash. If the

arbitrageur cannot come up with the cash, the securities in the fund are liquidated, often in fire

6 Collateral is a word used for assets that secure a debt obligation. For example, in the case of a mortgage the

house serves as the collateral for the mortgage loan. This way, the bank is secured against the default risk of the borrower not being able to meet the interest payments. In case of default the bank can sell the house and get its money (or at least a part of it) back. 7 Equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and funds in anticipation of income from dividends and capital gain as the value of the stock rises


Seite 11 von 13 17.02.2007

sales that fetch extremely low prices, with the result that the markets become still less

efficient, and the position of an arbitrageur still more precarious.”

A serious problem with involuntary liquidation by creditors is front running8. “If the bank in

question knows […] that the fund might liquidate holdings involuntarily, it has an incentive to

sell short9 the securities owned by the fund and to buy them back at lower prices, when the

fund is actually liquidating, possibly from the fund itself. The result of such short-selling is to

put downward pressure on prices and to accelerate liquidation.“

Finally, our model assumes that “all arbitrageurs have the same sensitivity of funds under

management to performance, and that all invest in the mispriced asset from the beginning.” In

fact, arbitrageurs differ. Some may have access to resources independent of past performance,

and might be able to invest more when prices are moving downwards. Hence these richer

arbitrageurs can partly undo the effects of PBA. However at some point they also make debts

to bet against the mispricing, as the mispricing gets deeper and feared future withdrawals

cause them to liquidate. In the extreme circumstances, they also are unlikely to stabilize the

market. At the end, “most arbitrageurs operating in a market are likely to find themselves

fully committed.”

Summary:

In our model, “PBA leads to potential instability of financial markets, particularly in extreme

circumstances.” This instability results from arbitrageurs and their creditors, who liquidate

when they are in money-losing positions, even when these positions have positive risk-

adjusted expected returns. “This instability manifests itself in substantial deviations of

security prices from fundamental values in time of crises, but also in large losses of the

arbitrageurs, their counterparties, and other financial market participants.” “Although lags in

liquidations, diversification and the presence of arbitrageurs whose resources are not

responsive to past performance ameliorate this problem, they are unlike to do so completely,

especially in a crisis.”

4.4 Long Term Capital Management

8 Front running is the illegal practice of a stock broker trading a security based on inside information before his or her clients have been given the information. 9 Short selling is selling something short that one does not (yet) own. Most investors "go long" on an investment, hoping that price will rise. Short sellers borrow a security and sell it hoping that it will decrease in value so that they can buy it back at a lower price and keep the difference.


Seite 12 von 13 17.02.2007

One empirical example for inefficient market and limited arbitrage was the fall of LTCM. In

1998 “Russia defaulted on most of its ruble-denominated debt [government bonds] and

sharply devalued the ruble.” Furthermore it “imposed a moratorium that froze Western

investors’ accounts in which these ruble-denominated bonds were held, as well as disabled

Russian banks from paying off their private debts to Western creditors.” However Russia did

not, default on its foreign debt. The consequences of these actions were manifold.

A large fraction of Russia’s ruble-denominated debt at this time was held by Western hedge

funds. Many of the Western hedge funds expected Russian’s default on domestic (ruble-

denominated) debt. They hedged their risks by “selling short Russia’s foreign debt (on the

theory that Russia is unlikely to default on domestic market without defaulting on foreign

market) as well as selling the rubles forward to Russian banks”, because theory says that if

Russia devalues, they can at least benefit from their short position in the ruble. However as

we mentioned before, Russia did no default on its foreign debt and imposed a moratorium on

payments by its banks. As a consequence, neither of these hedges worked. Most hedge funds

investing in Russia suffered severe losses. Moreover some hedge funds used non-Russian

securities as collateral. After the default, these funds had to pay off their debt or else to face

liquidation of collateral. Hence many of them started liquidating other emerging markets

positions. In addition, bad news from Russia reduced the valuation of emerging markets

securities, which were liquidated in fire sales. Moreover, these liquidations spread to other

markets and became to a serious problem for the economy. In general only “the funds

survived which were more diversified, less leveraged, and better positioned vis-à-vis the

creditors.”

The best known hedge fund, which suffered from large liquidations, was Long Term Capital

Management (LTCM)10, a very large, leveraged fund. The basic idea behind investments of

LTCM was that over time the value of long-dated bonds would tend to become identical.

However the rate at which these bonds approached this price would be different, and that

more heavily traded bonds would approach long term price more quickly than less heavily

traded and less liquid bonds. After this fund lost half of its equity, many creditors (who

demanded cash or addition collateral) liquidated its portfolio at fire sales prices. Though

creditors only “reduced the value of their collateral and thus suffering huge losses on their

loans to LTCM.” “Hence the central problem was the uncoordinated efforts by separate

creditors to liquidate their collateral”, which resulted in large losses to all of them. These “fire

10 http://en.wikipedia.org

Long-Term Capital Management, last access: 3.01.2005


Seite 13 von 13 17.02.2007

sales seriously distorted the market and elevated uncertainty enough “to damage economy

seriously. The fear of a chain reaction existed, i.e. companies liquidate their securities to

cover their debts, and leading to a drop in prices which would force more companies to

liquidate their own debt, creating a vicious circle. LTCM was finally rescued by a small group

of investors, who “took 90 percent of the equity” and “wiped out the existing shareholders

other than LTCM’s partners.”

The fall of LTCM is an important example of the principle that arbitrage is not risk less. This

undermines the claim of efficient market theorists that markets must converge instantaneously

to efficient prices because of the action of rational investors.

Ironically, they were right long-term, the value of the government bonds did eventually

converge and the folded portfolio became very profitable. “However the long-term does not

matter if you cannot survive the short-term; this they failed to do.”11

Sources:

Jonathon E. Ingersoll: Theory of Financial Decisions Making. - New Jersey: Rowman & Littlefield Publishers,

1987.

Andrei Shleifer: Inefficient Markets. An Introduction to Behavioural Finance. - Oxford, New York: Oxford

University Press Inc., 2000.

http://en.wikipedia.org

Definitions for limits to arbitrage, assets under management, noise trader, leverage, equity investment, short

selling, collateral, front running

Last access: 03.01.2006

11 See above

Documents

Professional Arbitrage - Inefficent Markets (based on Shleifer)