My understanding, and someone correct me if I’m wrong, the only way to diversify Fundamental Risk is to have a pairs-trade with perfectly substitutes. In doing so, you’re left with just Noise Risk (risk that traders will push the value of the stock further in a direction based on psychological factors ie: volume, patterns etc rather than fundamentals). The problem is that perfect substitutes are hard if not impossible to find. As a result, you will be subject to both Fundamental and Noise Risk in a pairs trade. In addition, the pricing discrepancy can persist because: #1. Risk-averse arbitrageurs will not be willing to take a longer term large position to remove the pricing discrepancy. #2. Even a large # of trades by small investors will not remove the inherent risk because Fundamental Risk cannot be diversified away. Does this make sense?
Yes.
PJStyles Wrote: ------------------------------------------------------- > My understanding, and someone correct me if I’m > wrong, the only way to diversify Fundamental Risk > is to have a pairs-trade with perfectly > substitutes. In doing so, you’re left with just > Noise Risk (risk that traders will push the value > of the stock further in a direction based on > psychological factors ie: volume, patterns etc > rather than fundamentals). > > The problem is that perfect substitutes are hard > if not impossible to find. As a result, you will > be subject to both Fundamental and Noise Risk in a > pairs trade. In addition, the pricing discrepancy > can persist because: > > #1. Risk-averse arbitrageurs will not be willing > to take a longer term large position to remove the > pricing discrepancy. > > #2. Even a large # of trades by small investors > will not remove the inherent risk because > Fundamental Risk cannot be diversified away. > > Does this make sense? #2 doesnt make sense to me
In a pair trade you eliminate the fundamental risk (market risk) but will always be subject to noise trader risk…the risk the overvalued (the one you’ve shorted) stocks don’t revert back to their intrinsic value and that undervalued stocks (the one you’re long on) become even more undervalued.
Flames, in a pair trade you ONLY eliminate fundamental risk if you have PERFECT substitutes… That is the CFAI Way.
Comp Sci Kid… why doesn’t #2 make sense? essentially, what I’m saying is that not only will risk-averse arbitrageurs not be willing to make sufficiently large trades to remove the price discrepancy, large # of small traders will not have the necessary impact because fundamental risk cannot be diversified away when the pair trade involves non-perfect substitutes.
Right, I was assuming perfect subsitutes (i.e. same risk exposures).
good posting PJ Styles very useful
PJStyles Wrote: ------------------------------------------------------- > Comp Sci Kid… why doesn’t #2 make sense? > essentially, what I’m saying is that not only will > risk-averse arbitrageurs not be willing to make > sufficiently large trades to remove the price > discrepancy, large # of small traders will not > have the necessary impact because fundamental risk > cannot be diversified away when the pair trade > involves non-perfect substitutes. pricing discrepancy and fudnamental risk is different. Yes, fundmanetal risk wont be removed but it doesnt explain why there is still will be mispricing. #1 explains it
CompSciKid… check the Scwheser notes in the section on pricing discrepancy and the 2 reasons why it persists. I’m pretty sure it mentions both of those reasons as explanations for the persistant price discrepancy.