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At a recent seminar on Capital Market Efficiency, David Thorngate, a seasoned arbitrageur wanted to dispel the notion that all arbitrage trades are successful. During his speech, he made the following statements regarding arbitrage and the ability of arbitrageurs to correct market anomalies:

Statement 1: There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is undervalued or overvalued relative to another does not mean that trading on this information will be profitable.

Statement 2: Even in "pairs trading," where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. So, there is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

Are Statement 1 and Statement 2 as made by Thorngate correct?

Statement 1

Statement 2

A)

Incorrect Correct

B)

Correct Incorrect

C)

Correct Correct

There are limits on the ability of arbitrage to bring about efficient prices. Arbitrage is frequently risky. Just because fundamentals indicate that one stock is overpriced relative to another, or absolutely over or underpriced, doesn’t mean that trading based on this information will be profitable.

Even in pairs trading, where an arbitrageur buys the underpriced security and shorts the overpriced security, significant risk from stock-specific factors remains. There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

A)	Arbitrage is a relatively riskless activity, which has led to consistently reduced profits for many arbitrageurs, thereby reducing their interest in correcting market anomalies.

B)	Arbitrageurs are sophisticated traders but their short supply precludes the correction of market anomalies.

C)	There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term.

There is no guarantee that even correctly identified relative mispricings of similar stocks will be corrected in the near term. Investors of the funds that arbitrageurs and traders use can be notoriously impatient, removing funds when trades go against them or if results are not consistently good. Since capital is limited, in periods where there are many apparent mispricings, arbitrageurs will direct capital only to pursue the most attractive trades, leaving other mispricings unexploited.

Which of the following statements about arbitrage and market anomalies is most accurate?

A)	If an arbitrageur correctly identifies relative mispricings of similar stocks the correction will take place immediately in the marketplace.

B)	In pairs trading, where an arbitrageur purchases the underpriced security and shorts the overpriced security, stock-specific risk remains.

C)	Investors of the funds that arbitrageurs and traders use are generally too patient and fail to remove funds in a timely manner when trades go against them.

Which of the following statements best describes the limits of arbitrage in correcting market anomalies?

A)	There is no limitation to arbitrage in correcting market anomalies because it is a riskless trading activity and once there is a mispricing it will be exploited to its fullest.

B)	Arbitrage is not always riskless as was shown during the internet stock bubble of the 1990s, when traders were short a stock and had to cover their positions at a much higher takeover price.

C)	When fundamentals indicate that a stock is overvalued or undervalued, trading based on this information will be immediately profitable.

There are limits on the process of arbitrage to bring about efficient prices. Arbitrage is frequently not riskless. Just because fundamentals indicate that one stock is overpriced relative to another, or absolutely over or underpriced doesn’t mean that trading based on this information will be immediately profitable. One risk with shorting overvalued stocks during the internet stock bubble of the late 90s was that a stock a trader sold short would be taken over at a significantly higher price. The fact that the acquiring firm paid too much for shares offers no solace to short sellers who have to cover their positions at the takeover price.