Reading 55: Market Efficiency and Anomalies- LOS b～ Q1-4

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LOS b: Describe four problems that may prevent arbitrageurs from correcting anomalies.

Q1. 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

Q2. Which of the following limits the ability of arbitrage to correct anomalies?

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

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

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

Q3. Which of the following statements about arbitrage and market anomalies is most accurate?

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

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

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.

Q4. 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.