Behavioral finance FAQ / Glossary (Arbitrage)

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APT

See Arbitrage Pricing Theory

(limited) Arbitrage

(absence of / limits of) Arbitrage opportunity

03/10i - 04/4i,5i - 08/1d
+ see EMH, RWH,
active investing, overtrading,
alpha

Making money, or hoping so, by swapping horses.

Definition:

An arbitrage is a simultaneous sell and buy operation by a person

* between two (or more) assets. Good bye asset A, hello asset B!

* or between two markets, on the same asset that is traded on both

Good bye - and nice to see you again, this is a small world - asset A!

 The purpose of a trader or investor who makes an arbitrage is:

Usually to make money from a temporary and (nearly) certain prices
    and returns discrepancy between those assets (or on the
    same asset).

A perfect arbitrage, that would offer the certainty of an extra
return without risk is usually called a "martingale"

In some cases, to answer some tax-related, legal or practical motives.

A theory against arbitrage

Nothing to gain?

Even if we get up early to catch the worm before the
whole trading nest wakes up?


The "absence of arbitrage opportunity" is one of the tenets
of various
standard theories such as the EMH, the RWH, the
CAPM (see those acronyms)
.

Those theories state that:

Markets prices are always fair , as if current individual
    prices,
as well as the general market risk premium, reflect

correctly all known information.

All assets with an identical risk offer the same return.

None brings a positive or negative "alpha" (see that word).


The price of this/those assets follow an unpredictable

   "random walk".

Their evolution would be made of sudden price moves every time
an unexpected and crucial information / event changes the
fundamentals.

This would not leave any small breathing time , once
     
the event is known, to buy and sell and make a profit, except
     
for the fastest gun (or electron). Thus:

In a traffic jam why try another lane, or change your
itinerary?

Why bother looking for opportunities?"

Stay at home and sleep, pheasants that are
already roasted will happily fall into your mouth!

According to that thesis and those "rational" assumptions, there is theoretically
no certainty of gain
(no arbitrage opportunity), not even in average, when
running a series of arbitrages, by

* either selling and buying back the same asset,

* or switching investments between assets with comparable risks.

No arbitrage nor arbitrage opportunity, really?

So, why there are so many arbitrages all the time,
all over the place?


In reality arbitrages take place constantly in asset markets.

Without them, markets would be nearly frozen .
The only people who would intervene would be

those finding themselves with "new money" they would be ready to
    invest,

and those who need their money back and need therefore to sell.


Whether those arbitrages are well thought martingales, or just impulsive /
hyperactive gambling (see overtrading / noise trading), the adepts of
the above theories would deride such operations as arbitrages in the
absence of opportunity
.

But arbitrages can also be considered as oil drops that lower frictions
in the market cogs,
help reestablish the right balance and thus
annihilate ...any arbitrage opportunity. The theory would be safe

That explanation is not fully satisfactory.

Arbitrage opportunities seems not only to exist
but also to persist.

Behavioral finance admits that phenomenon and
sees human biases as a main cause.

Here are some of the phenomena at play:

Price adjustments to economic realities take place often only
    after a long
delay (underreaction).

This leaves, for "trend followers", not fully exploited arbitrage
      opportunities.


Sometimes also, overreaction occurs after such a price
    adjustment.

Then the "correction" leads to imbalances in the other direction.

This creates some arbitrage opportunities for "contrarians"
      (see that word).


More generally, people have changing rational agendas,

and also variable emotional preferences and evolving 
cognitive biases in the presence of information.

They also tend to mimic the crowd .

Those attitudes do not reflect directly fundamental
     
information and risk / return evaluations.

They create holes in the efficiency tenet, and distortions
in the  
random laws. Those discrepancies might create
opportunities.


This glossary is the collector shop to find all those market behavior
curiosities, and also
the "image coefficient".

This helps to complement the risk / return tenet as the standard
"rational" pricing paradigm.
Between you and me, that seems to open some opportunities,
better not cut off that "o" word from your dictionary.

Cost and risk of frequent arbitrage

There are no more fully free arbitrages
than fully free lunches.


A related concept is the "limits of arbitrage".

Among such limits is the " cost of arbitrage", in other words
the transaction costs to sell an asset and to buy another.

That cost would be often higher than the advantage given by the spread
between their market prices.

This condemns overtrading / noise trading (see

 those phrases), at least for non professional, as the survival
  survival rate is low
.

Also there are arbitrage risks, the martingale is not fully safe,
all the more when it becomes highly leveraged arbitrage.

   But full passive investing is not better.

Some arbitrages are needed to adapt the portfolio to major
evolutions or to blatant mispricing.

The small cost involved should not be a deterrent then.

Arbitrage pricing theory (APT)

04/12i + see beta,
CAPM, effect

Market effects as space / time faults?

The APT / Arbitrage Pricing Theory isolates some market effects (see
effect)
that would offer an arbitrage opportunity (see that phrase),
whence the name.

In other words those assets (as well as some investment periods) would offer
a better return without more risk.

Among those discrepancies the best known ones are:

The P/E effect (often better future return when a stock P/E is low).

The size effect (better return for small firms as they are often
    underpriced):

The PBR / price to book ratio effect, etc.

The calendar effects, the weather effects...

Be careful, those effects cannot be considered 100%
      reproducible
.

They can vanish precisely when playing them becomes the investors'
craze.

Alphas? Or baby betas?

That theory splits the beta coefficient (see beta) into several coefficients.

Every one of those baby betas is linked to a specific effect / anomaly.

But you might also call this kind of effect an "alpha" (see alpha).

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