Friday, August 10, 2007

Today Is a Great Day in Finance!

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."

(Via Brad DeLong's Blog.)


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