Today Is a Great Day in Finance!

Today is a great day in finance! That is, it is a great intellectual day for those of us who are friends of and committed to the intellectual project of Shleifer and Vishny, for today one of their theories is made flesh, and stomps about Wall Street like Godzilla:

Andrei Shleifer and Robert W. Vishny (1997), "The Limits of Arbitrage," Journal of Finance, 52:1, pp. 35-55. Abstract: Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital, and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances, when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them...

Yes, today we have reached the limits to arbitrage: most of the people who spend their lives trying to buy low and sell high using other people's money and leverage have given up extending their positions (and so pushing prices back toward normal-time fundamentals), and are hunkered down simply hoping to survive the next month.

Whether this will have macroeconomic implications is unclear, but I would bet not. The Fed and the ECB are pegging the prices of liquid securities, and injecting as much in the way or safe, liquid, short-term assets into the system as needed to keep that so. They are also in the market in other ways. And the nightmare scenarios always involved a simultaneous collapse in the dollar and in consumer demand, and a Fed that couldn't decide whether to fight the inflation coming from rising import prices or the unemployment coming from collapsing consumer spending. Neither of those show any signs of happening.

Yet.

http://scholar.google.com/scholar?q=shleifer+vishny+limits+to+arbitrage&num=100&hl=en&c2coff=1&safe=off&client=safari&rls=en-us&pwst=1&um=1&oi=scholart

Comments

[Hal]

"Yet."

And meanwhile the market veers and lurches like a drunk on the highway having no idea where he is going.

[burritoboy]

"Yes, today we have reached the limits to arbitrage: most of the people who spend their lives trying to buy low and sell high using other people's money and leverage have given up extending their positions (and so pushing prices back toward normal-time fundamentals), and are hunkered down simply hoping to survive the next month."

Until people start to raise distressed collateralized debt workout funds, which should start within the next eight weeks. I unfortunately don't have the expertise myself to start one of these, but if I did, I'd already be prepping my powerpoint investor presentation and nailing down my prime broker.

[dibert dogbert]

This kind of reminds of the day when a guy walked into my office and said: The market just tanked - it is down 500. I said: We have crossed the Rubicon,- I wonder what will happen next. At the time I thought a lot of very smart people were working overtime to make sure what happens next is not a disaster.
Monday will tell a story.

[christofay]

"Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital."

But we don't know how small the set of smart investors are who were modeling. The true small set of arbitragers have to be the members of BS management who sold before the trouble hit. With liquidity a small set also borrows a large position. But the set isn't that small, it's lots of LTCMers. Just a few weeks ago this blog's topic was about meeting the Portfoliolio's levered finance blog writer and how, I guess, the problem was contained or no scarier than a blog post.

[christofay]

Falls happen in fall except in Indian Summer.

[Miracle Max]

Yes and Black Tuesday was a great day for studying the law of gravity.

[christofay]

Yippee, let's run outside and play central banker. We pretend to cure the sickness we induced.

What dude central banker in the early 2000s said it would be fun to fight deflation? And that WMD only turned out to be falling used car prices partially due to the availability of cheap new car financing.

[lgm]

The term "arbitrage" is used in different ways by different people. The academic definition is: an investment with zero probability of negative return and positive probability of positive return. Nobody in the finance industry thinks this kind of arbitrage exists any more than physicists think there are frictionless elephants.

The term seems to have degenerated (particularly in combinations like "index arbitrage" or "statistical arbitrage") so that it now means something like: "I'm going to be smart, high tech, data driven, secretive, invest in more than one instrument, and hopefully beat some index."

It's risky because it assumes that there is no reason for what you think are mis-pricings. More likely, there is a reason that you don't know.

[lgm]

The term "arbitrage" is used in different ways by different people. The academic definition is: an investment with zero probability of negative return and positive probability of positive return. Nobody in the finance industry thinks this kind of arbitrage exists any more than physicists think there are frictionless elephants.

The term seems to have degenerated (particularly in combinations like "index arbitrage" or "statistical arbitrage") so that it now means something like: "I'm going to be smart, high tech, data driven, secretive, invest in more than one instrument, and hopefully beat some index."

It's risky because it assumes that there is no reason for what you think are mis-pricings. More likely, there is a reason that you don't know.

[gwui]

If Fed is buying mortgage-backed securities, does it mean US Government partially owns those mortgages? If those mortgages are going to default or prepay, does that qualify as a buyout? And if it does, how does it compare in size with the other buyouts (S&L)? And how does it bear on the efficiency of free enterprise system, if it has to be bailed out at the taxpayers' expense?

[Michael Peter]

I love that quote...:

"...Today is a great day in finance! "

Thank you very much :-)