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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.

Key points

• Refers to constraints that prevent traders from fully exploiting arbitrage opportunities.

• Factors include liquidity constraints, transaction costs, regulatory restrictions, and risk aversion.

• Can allow market inefficiencies and pricing anomalies to persist.

Quick Answers to Curious Questions

Liquidity constraints, transaction costs, regulatory barriers, and risk aversion are common limits that prevent arbitrage opportunities from being fully exploited.

They can allow pricing inefficiencies to persist, preventing markets from quickly correcting anomalies.

High transaction costs, risks, and other barriers can limit the ability of traders to execute arbitrage, allowing price discrepancies to persist.