Limits to Arbitrage

Limits to arbitrage refer to the constraints that prevent traders from fully exploiting market inefficiencies. In theory, arbitrage opportunities should lead to risk-free profits by simultaneously buying and selling assets in different markets. However, in practice, factors such as liquidity constraints, regulatory restrictions, transaction costs, and risk aversion can limit the ability to execute arbitrage strategies. These limits can allow pricing anomalies to persist for longer than expected.

Example

A pricing discrepancy exists between the U.S. and European markets for a stock, but high transaction costs and currency risks prevent arbitrage traders from fully exploiting the opportunity.