Limits of the Arbitrage

Behavioral Finance is the study of the way in which psychology influences the
behavior of market practitioners, both at the individual and group level, and the
subsequent effect on markets. It is concerned with the analysis of various
psychological traits of individuals and how these traits affect the manner in which
they act as investors, analysts, and portfolio managers Sewell (2010). According
toThaler and Barberis (2002), behavioral finance has two building blocks: limits to
arbitrage and psychology. Limits to arbitrage seek to explain the existence of
arbitrage opportunities which do not quickly disappear.
Theory of Limits to Arbitrage has provided over the years include: the equity
premium puzzle which refers to the empirical fact that stocks have out-performed
bonds over the last century Benartzi and Thaler (1995), Sewell (2005), Thaler and
Barberis (2002), the conservatism principle of share prices, which states that
earning reflect bad news more quickly than good news Basu (1997), the tendency
of investors to sell winning investments too soon and hold investments for too long
Odean (1998), overconfidence of investors Daniel, Hirshleifer and Subrahmanyam
(1998), Camerer and Lovallo (1999) , herding behavior in the financial markets
Wermers (1999) among others, and is nowadays yielding insight into the effects of
social networks (such as the number of Facebook Likes and the number of
good/bad tweets) on stock prices of publicly traded companies.
Behavioral Economics is the combination of psychology and economics that
investigates what happens in markets in which some of the agents display human
limitations and complications. Saving for retirement requires complex calculations
and willpower, behavioral factors are essential elements of any complete
descriptive theory. Mullainathan and Thaler (2000). The behavioral finance
literature also provides several possible explanations.
There are two main definitions of efficient markets, one ambitious and the other
modest. The ambitious definition is better called rational markets. Rational markets
are markets where the 'the price is always right.' Specifically, these are markets
where securities' prices always equal their intrinsic values. The modest definition
of efficient markets is as unbeatable markets. Unbeatable markets are markets

where investors are unable to generate consistent excess returns. (Statman (2011).
Rational markets are unbeatable because excess returns come from exploiting gaps
between prices and intrinsic values, gaps absent in rational markets. But unbeatable
markets are not necessarily rational.
Arbitrage, defined as "the simultaneous purchase and sale of the same, or
essentially similar, security in two different markets for advantageously different
prices" Sharpe and Alexander (1990). Arbitrage requires no capital and entails no
risk. When an arbitrageur buys a cheaper security and sells a more expensive one,
his net future cash flows are zero for sure, and he gets his profits up front.
Arbitrage plays a critical role in the analysis of securities markets, because its
effect is to bring prices to fundamental values and to keep markets efficient. For
this reason, it is extremely important to understand how well this textbook
description of arbitrage approximates reality. This article argues that the textbook
description does not describe realistic arbitrage trades, and, moreover, the
discrepancies become particularly important when arbitrageurs manage other
people's money.
In particular, the implications of the fact that arbitrage-whether it is ultimately riskfree or risky- generally requires capital become extremely important in the agency
context. In models without agency problems, arbitrageurs are generally more
aggressive when prices move further from fundamental values Grossman and
Miller (1988), De Long et al. (1990), Campbell and Kyle (1993).

http://ms.mcmaster.ca/~grasselli/ShleiferVishny97.pdf
http://www.palermo.edu/economicas/PDF_2012/PBR7/PBR_01MiguelHerschberg.
pdf
http://www.russellsage.org/sites/all/files/Rethinking-Finance/Shefrin%20Statman
%2001272012.pdf