Research on limits to arbitrage can shed interesting new light on financial behaviour and its impact on markets
Since the financial crisis there has been much hand-wringing over excessive risk-taking by traders in financial markets, and earnest questioning about the reasons for this behaviour. They were paid too much in bonuses, cry some people. They were set a bad example by their leaders, say others. The loudest call is from those who claim that the whole system is dysfunctional and unethical.
In reality, financial behaviour is much more complex than any of these arguments would suggest. In my research I have conducted a number of studies that looked at the factors that influence the actions of people involved in one form of trading: arbitrage. I found a network of surprising and interconnected motives that can arise from financial institutions’ organisational structures, from capital constraints, and from availability of information.
Arbitrage is the exploitation of price discrepancies in financial markets. Assets may be mispriced, having diverged from their intrinsic value, or they may have price variations in different markets – or they may be discounted, as sellers want to get rid of them quickly.
Traders who engage in arbitrage are doing so to make a profit, of course, but at the same time they are contributing to market efficiency (as more traders take advantage of arbitrage opportunities, the price discrepancies are corrected). They can also act as intermediaries between different markets, contributing to the liquidity of those markets.
So a totally efficient market would have no arbitrage. As it still so clearly exists, it raises the question of whether traders are always fully taking advantage of price differences – and if not, why not.
One study (co-authored with Mariassunta Giannetti from Stockholm School of Economics) was based on an analysis of about 1,500 US-based funds over 20 years. It revealed that the open-ended structure of most investment vehicles, which allows investors to invest or withdraw capital at any time, discourages asset-managers from trading against mispricing.
Because investors typically lack the specialised knowledge to evaluate a fund manager’s strategy, they tend to assess the manager on the basis of recent past performance. If a long-term strategy to exploit mispricing fails to yield results in the short term, investors may interpret it as evidence of incompetence on the part of the manager. If the fund is open-ended, they are likely to react by refusing to provide more capital or even by withdrawing some or all of it.
As a result, asset managers in open-ended funds tend to ignore mispricing when they think that it will take a long time for asset prices to correct to their fundamental values. In contrast, managers of closed-end funds, who do not have to worry about investor withdrawals, are shown to take more aggressive positions against mispricing, and particularly to be willing to buy risky ‘fire sale’ stocks, which are trading well below their intrinsic value.
In another study, in which I worked with Heather Tookes from Yale School of Management, we used the unique features of the margin trading system in India to explore the idea that variation in traders’ ability to use leverage (that is, to borrow in order to invest in risky assets) can cause sharp changes in a stock’s market liquidity – the ease with which it can be sold at a stable price.
As elsewhere, margin trading in India allows investors to borrow up to 50% of the purchase price of a stock, but only some stocks are eligible for margin trading. By examining the trading patterns of stocks immediately above and below the cut-off point for margin trading, we were able to look at how traders’ behaviour changed when they became more or less capital constrained.
We discovered that margin traders tend to follow contrarian trading strategies, going against prevailing market trends by buying assets that are performing poorly and then selling when they perform well. This provides liquidity to the market and helps prices to stabilise. We also found that improvements in liquidity are higher when margin traders are more active. However, during extreme downturns, traders stop following contrarian strategies: instead of being liquidity providers they become liquidity seekers. This shift in their trading behaviour becomes detrimental to the market as selling into fire sales exacerbates negative shocks and leads to liquidity dry-ups.
Does revealing arbitrageurs’ trading strategies to the public improve or worsen market efficiency? On March 6, 2007, the SEC approved amendments that revised the short interest reporting of all major securities exchanges and the Financial Industry Regulatory Authority, requiring members to increase the frequency of reporting from once per month to twice per month.
Short-sellers are informed investors who possess superior information about company fundamentals. Revealing their short interest – the number of stock shares that they have sold short but not yet covered or closed out – indicates to market participants that short-sellers think stock prices are likely to fall. In our joint work with Salil Pachare from the Securities and Exchanges Commission, we analysed trading patterns before and after the new reporting requirements kicked in. Our analysis showed that more frequent disclosure of short interest helps the investing public learn faster and eliminate errors in expectations. This contributes to improved market efficiency.
In addition, short-sellers become more willing to attack long-term overpricing with higher public disclosure of short positions. Previously they could be hesitant to attack a mispricing because of horizon risk – the risk that the mispricing can take too long to correct. With higher public disclosure of short positions, other traders learn from short-sellers readily and help incorporate their information into prices more quickly.