Lesson 4 of 7
Right, and early
Professional arbitrage uses other people's money, so it shrinks when prices move against it. The mispricing is largest exactly when the capital is smallest.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- Textbook arbitrage needs no capital and carries no risk. Real arbitrage needs capital, carries risk, and is done by specialists using other people's money.
- When prices move further from value, those specialists lose money and face withdrawals, so they have to shrink positions rather than add to them.
- The capital that is supposed to correct a mispricing is therefore smallest exactly when the mispricing is largest.
The efficient market argument depends on informed capital acting. This is the lesson about what happens to that capital while it waits, and it is the strongest answer to the question of why a visible mispricing does not simply disappear.
The sequence Shleifer and Vishny describe
- Step 1The position is openedA specialist identifies a mispricing and invests client money in it.
- Step 2The price moves against itThe mispricing widens. The fund shows a loss.
- Step 3Clients withdrawMoney is taken back on the basis of recent performance.
- Step 4Positions are cutThe specialist sells into the mispricing, pushing the price further from value at the moment the opportunity is best.
What the paper argues
Shleifer and Vishny begin by separating the textbook picture from the real one. Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital and is typically risky, and professional arbitrage is conducted by a relatively small number of highly specialised investors using other people's capital.
That last phrase is the whole mechanism. When the arbitrageur's money belongs to somebody else, the money can leave, and it leaves on the basis of recent results rather than on the basis of the opportunity.
The conclusion that matters
They call this performance-based arbitrage, and they argue it is particularly ineffective in extreme circumstances, where prices are significantly out of line and arbitrageurs are fully invested. In those circumstances arbitrageurs might bail out of the market when their participation is most needed, becoming the least effective in reducing mispricing precisely when it is greatest.
They also note that the fear of this outcome makes arbitrageurs more cautious when putting on the initial trade, which makes them less effective at correcting prices even before anything goes wrong.
What this means for an individual
It is the closest thing to a structural advantage in this whole course, and it has to be stated carefully.
An individual investing their own money cannot be redeemed. Nobody can withdraw their capital in the third losing year, and nobody reviews their quarter. If a mispricing takes seven years to close, that is a problem for a fund with annual redemptions and merely uncomfortable for a person who does not need the money.
The caution is equally important. That advantage is only real if the position was sized so that it can be held through the fall, and if the reason for holding it was written down before the fall started. An individual with borrowed money, or with a position large enough to force a sale, has imported the fund's problem into their own account.
Check yourself
What makes real arbitrage different from the textbook version?
- It is illegal in most markets
- It requires capital, carries risk, and is conducted by specialists using other people's money
- It can only be done by individuals
Show the answer
Answer: B.
The paper's opening contrast is exactly this, and the third point is what generates the limits it describes.When is performance-based arbitrage least effective?
- When prices are close to fundamental value
- In extreme circumstances, when prices are far out of line and arbitrageurs are fully invested
- When interest rates are low
Show the answer
Answer: B.
That is the paper's central result: arbitrageurs may bail out when their participation is most needed, so correction is weakest when mispricing is largest.What is the individual's version of this advantage, and its condition?
- They can borrow more cheaply
- Their capital cannot be redeemed, provided the position is sized to be held through a fall and the reason was written down first
- They pay no trading costs
Show the answer
Answer: B.
The absence of redemption is structural. It only helps if leverage and position size do not recreate the forced seller inside the account.Sources
- Shleifer and Vishny, "The Limits of Arbitrage", Journal of Finance, volume 52, number 1, March 1997, pages 35 to 55: the contrast between textbook and real arbitrage, professional arbitrage conducted with other people's capital, performance-based arbitrage and its ineffectiveness in extreme circumstances, and the commercial bank stocks of 1990 and 1991.
What this leaves out
- The paper is a model plus illustrations. It explains why mispricing can persist; it does not measure how much persists or where.
- The example of bank stocks is the authors' own, described as they describe it, with no figures attached here.
- Nothing here says any current price is wrong, or that patience by itself produces a return.
- None of it is advice about any security.