Which of the following statements best describes the limits of arbitrage in correcting market anomalies? A) When fundamentals indicate that a stock is overvalued or undervalued, trading based on this information will be immediately profitable. 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) There is no limitation to arbitrage in correcting anomalies because pairs trading eliminates any risk from stock-specific factors. D) 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.


I think this is a Schweser question and their answer is B.

yep it is a schweser question and b is the answer ! did you get it first time round? i chose d… i have always thought of arbitrage as a riskless opportunity to profit from mispricing!

My take : Definitely not A, as fundamental analysis will take longer to correct for mispricings, or even not at all depending on strictness of EMH. For B, this is a good example that shorting a stock by hedging with longing another security is not necessarily always riskless. For C, this seems to be violated by B because with pairs trading you short one and long another, hoping to switch your position after the prices cross. However, you run into risk mentioned in B. For D, this seems to be even more general than C and should be abandoned as well. Sometimes arbitrage can be riskless, eg in FOREX markets, if you demonstrate that trading dollars to yuan to euros and then shorting direct euros-to-dollars you can profit. But to state it is always riskless, regardless of market or asseet type, seems too much a stretch.

yes, I guessed and was pleasantly surprised when it turned out right…

hedging and arbitrage is not the same though

i am still not convinced that B is a good answer

me neither

florinpop Wrote: ------------------------------------------------------- > i am still not convinced that B is a good answer Why not? A common pairs-trading arbitrage opportunity is to find two stocks that mean-revert, and to continuously long the cheap one and short the expensive one, and repeat each time they mean-revert. Answer B demonstrates a specific risk that could happen, even if you find the perfect pair of mean-reverting stocks.

because if i am not wrong arbitrage would mean entering into two opposite positions at the same time maybe somebody that works in the industry could help us

florinpop Wrote: ------------------------------------------------------- > hedging and arbitrage is not the same though Of course, but as far as I know, nearly all arbitrage opportunities involve setting up a hedge that is guaranteed to return a profit. Usually by buying A and selling B (and maying buying some C and selling some D, and so on) such that at the current price levels and reasonable assumptions of liquidity one can make a profit. Unless I’m mistaken, can you provide an example of arbitrage that does not involve a hedging of some sort?

Def: The simultaneous purchase and sale of similar commodities in different markets to take advantage of a price discrepancy. which is why traders having to cover their position at a higher price doesn’t make sense to me

that is exactly what i am saying on the other hand D) 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. the mispicing can not be exploited to its fullest because of trading costs an timing issues that is why i went for C for me it’s a bad question

the mispricings are always corrected by shorting A and longing B, although sometimes by circuitous paths. However suppose you short $1M notional of a software company, which you determine is a good pairs-trading candidate. And before you can blink it is announced on Bloomberg that the software comany is going to be bought out by MSFT at a premium to its market cap. You are now hosed.

see for me that is hedging arbitrage would be buying gold on london and selling it in the same time in chicago because there is an arbitrage opportunity

i think what stratus is trying to say is it’s not always possible to place a trade immediately after one at the exact price you were hoping to lock a profit in to. and that’s why it’s not completly riskless. esp in a volatile market. at least that’s how i’m justifying B

Florinpop, your example of buying gold in London and selling in Chicago is actually hedging. In textbook land, these markets would be perfectly efficient and you’d hedge all risk (and all profit) away.

i knew that with arbitrage you lock in a rate of return from the beginning of the trade with hedging you cover you position which is not always locking a return just look at the example with treasury notes and commodities treasury notes are under inflation risk and comodities rise with inflation buying comodities would hedge your inflation risk but i dont know this stuff to good since i dont work directly in investments

I just had this question from the qbank. I thought it kind of contradicted answer B saying that: Arbitrage is not always riskless. Here is the question I just came across: Which of the following is NOT one of the conditions that must be met for a trade to be considered an arbitrage? A) There is no risk. B) There are no commissions. C) There is a guaranteed profit. D) There is no initial investment. Your answer: A was incorrect. The correct answer was B) There are no commissions. ***In order to be considered arbitrage there must be no risk in the trade.*** It doesn’t matter if commissions are paid as long as the amount of the price discrepancy is enough to offset the amount paid in commissions. There must be a guaranteed profit in an arbitrage trade. In order to be considered arbitrage there must be no initial investment of one’s own capital. One must finance any cash outlay through borrowing.