I encountered this issue in the practice problem at the end of reading 13 in CFA curriculum. The statement of ‘trading friction is beneficial to arbitrageurs because it provides higher return’ is recognized as incorrect, for the reason of ‘trading risk is a chronic inefficiency that can persist and be hard to exploit’. Intuitively, trading friction to me leads to adverse effect on profits caused by transaction costs and illiquidity. Then despite HFT may profit in this area by exploiting such opportunity, as Deniz Anginer observed in this paper (Liquidity Clienteles: Transaction Costs and Investment Decisions of Individual Investors http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1620034), investors with holding periods that relate positively to trading frictions earn higher gross and net returns hence sophisticated investors appear to recognize the importance of trading friction to net return and gauge holding periods accordingly. My understanding on this issue and the given answer therefore not reconcile. May I ask your opinion on this issue? Any inputs are much appreciated. Fei
My CFA studying philosophy: If it’s not in the reading, it doesn’t exist. Anginer may very well be correct empirically, but as far as the curriculum (Leibowitz) is concerned (Pg. 83-84) trading frictions create chronic inefficiencies. Chronic is the key word. The inefficiencies can be quite persistent, and as it says in the last line, “The market can remain irrational far longer than you can hang on to your position - or your career.”
Thanks for your reply Alex. I actually was thinking the very same line as you mentioned in the end, in which I tried to set up a conneciton between such irrationality and trading costs as well as illiquidity.To me, irrationality (from the stand point of a trader’s belief) could cause drain on liquidity and higher spread, and yes I agree it could be quite persistent. However, it doesn’t necessarily mean the reverse of the statement is also true that trading friciton is exclusively caused by irrationality and chronic inefficiencies. In this sence, I suspect I’ve got wrong interpretation of trading friction for a right answer. May I ask your opinion on connections between trading friciton and chronic inefficiency?