Limits of Arbitrage

In financial markets, bubbles and crashes oc­cur from time to time which seems to reject the idea of efficient markets and the positive effect of arbitrage. For example, the NASDAQ Index rose from about 1000 in late 1997 to more than 4500 in March 2000 before declining to 1000 in March 2003.

Several models within the rational framework were developed to explain the limits of arbitrage. If the investment horizon is shorter than the time until the fundamental value of an asset is reached, serious mispricing remains a possibilty. Moreover, mispricing can be the result of noise traders as they create additional risk by trading randomly. This additional risk is priced by the market. If noise traders take this additional risk by trading irrationally, they can earn higher returns than rational investors. In other words, irrational investors are not necessarily eliminated from the market due to their losses. It is shown that noise trader risk can worsen mispricing in the short run. If arbitrageurs have short investment horizons, noise trader risk will prevent them from exploit­ing this mispricing. The literature shows that the survival and the price impact of irrational traders are two independent concepts: They find that the price impact of irrational traders does not rely on their survival in the long- run and that they can influence prices even when their wealth becomes negligible (Glaser et al., 2003, p. 7). At this point it is necessary to note that Fama defined the dis­cussions mentioned in the previous subsections as anomalies in the market (Fama, 1998 p.283).