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Discuss the limits to arbitrage. Your answers should include theoretical as well as
real-world examples.
Definition of arbitrage: * the simultaneous purchase and sale of an asset in order to
profit from a difference in the price.
* It is a trade that profits by exploiting price differences of identical or similar
financial instruments, on different markets or in different forms.
* Arbitrage exists as a result of market inefficiencies; it provides a mechanism to
ensure prices do not deviate substantially from fair value for long periods of time.
Limits to arbitrage
Theoretical issues
1. Fundamental risk
Often there are no identical assets that have identical cashflows. Arbitrageur is
therefore exposed to fundamental risk. i.e. the asset they buy and short are not
identical therefore exposed to different risks.
2.Noise trader risk
Noise traders that drive prices away from fundamental values can continue to be
overly optimistic or pessimistic so mispricing can remain
3.Implementation costs
Borrowing costs associated with shorting can be to high to justify arbitrage
Transaction costs such as commissions, bid-ask spreads and price impact can
make arbitrage opportunities less attractive
These different factors cause limits to arbitrage, which can cause mispricing of
assets to continue, which goes against the EMH.
2 firms share the same BoD, reporting periods and accounting policies.