Market frictions and trading opportunities

A perplexing issue in finance is determining how traders make money if markets are efficient. Put differently, why do anomalies persist if markets are efficient? This has growing importance because there is the belief that the flood of money into hedge funds will force markets to equilibrium faster. Markets will become more efficient and the alpha that is produced by hedge funds will be diminished. 

A premise for efficiency is that markets are frictionless. If the price of an asset moves away from fair value, there will be a flow of capital that will come into the market and force the price back to fair market equilibrium. However, we have many market anomalies which suggest that movement to fair value does not occur immediately. 

Mispricing can exist for long periods of time and be quite large. Arbitrageurs are not able to overcome all of the frictions that may exist in the markets. Arbitrage is not always riskless because there may be cash flow uncertainty in constructing trades that move the market to fair value. This allows for market trading opportunities. 

The frictions that allow for long and large market mispricing have been described as the phenomena of slow moving capital. (See “Slow Moving Capital” by Mitchell, Pedersen, and Pulvino in the May 2007 American Economic Review.) They studied the merger market after the 1987 crash and the convertible bond market during the LTCM crisis and the redemption period of 2005. Their study of these examples concerning market is compelling. Traders may face capital constraints, information constraints, and liquidity restrictions, Shocks to capital or liquidity can have strong effects especially for specialized markets where the potential arbitrageurs are in some ways constrained. 

Arbitrage capital is actually limited or a scarce resource which can lead to persistent mispricing in the market. This is especially true in specialized markets such as convertible bonds. When you see mispricing in the market, it may be market frictions make capital movement to eliminate these mispricing slow. Markets that may face frictions are more likely to have premiums for those who are willing to take on these risks.