Limits to arbitrage - Rules and structure explain pricing anomalies

 

The limit to arbitrage is one of the most important concepts in finance next to arbitrage pricing. Arbitrage works in a world without frictions and constraints. If there are arbitrage opportunities, the first thing to think about is not market inefficiency or behavioral bias but market structures that can create barriers to effective arbitrage. 

Limitations, in general, can be caused by regulation, transaction costs, financing, lack of skill, and the lack of capital committed to arbitrage at any specific time. Many of these limits to arbitrage are focused on investment frictions or risks and not market structure or rules constraints. However, understanding institutions matter if a researcher wants to go down the path of looking for and exploiting price anomalies. 

Capital is constantly searching for the best return to risk and small deviation from equilibrium may not be enough to create a reason for capital to close an arbitrage gap. We are perhaps using the arbitrage term loosely. There are few true arbitrage opportunities. Capital has to be committed, financing has to be lock-in, and there has to be no competing similar opportunities. To understand the limits of arbitrage requires a strong institutional knowledge of market mechanics which often does not exist with academic researchers. 

A key issue faced with testing the limits of arbitrage is forming a comparison between an unconstrained versus constrained environment. This test of the limits of arbitrage based on institutional constraints has been elegantly presented in the paper, "The causal effect of limits to arbitrage on asset pricing anomalies" published in the October 2020 Journal of Finance. 

The authors use a novel approach to explore the limits of arbitrage for 11 pricing anomalies. Regulation SHO from the SEC relaxed the short sale constraint on stocks. The paper explains the details of Regulation SHO.  The key is that the changes in short sale rules allow us the compare before and after behavior and a comparison of those stocks with constraints and those without. Regulation, market rules, can create mispricing that would not exist otherwise. It is not a risk story or a behavioral story, but a story focused on market structure that drives mispricing. Remove the limits and the anomalies may disappear. The tables below summarize the main results of the work. 

It is harder to conduct equity arbitrage if you cannot effectively short a stock. Anomalies can continue for the simple reason that the arbitrageur cannot form a risk-free trade. Hence, those stocks which have short sale restrictions lifted will have the limit to arbitrage lifted. Pricing anomalies that existed before should disappear after the constraints are lifted. Similarly, since the short-side constraint was lifted, the excess returns from the anomaly should decline from the short-side of the trade. The researchers try this on a wide variety of strategies from momentum to return on assets. It does not change results in all cases, but a less constrained world is different. 

Mispricing driven by constraints, such short selling rules, is exactly what was found in this paper. When constraints are lifted, the out of the ordinary pricing that previously existed disappears. To trade in the real world, every researcher has to be an institutionalist.