Limits to arbitrage
What is limits to arbitrage?
Arbitrage means simultaneously buying and selling an asset to profit from a difference in its price. The theory of limits to arbitrage says that these prices may stay in an unbalanced state for a significant period of time due to restrictions on so-called rational traders.
Where have you heard about limits to arbitrage?
It is a term used in investment circles when discussing why price inequalities in assets may continue despite being identified by traders.
What you need to know about limits to arbitrage.
Arbitrage happens when a rational trader spots a price difference in an asset in two different markets and invests accordingly. The efficient market hypothesis states that this intervention will help correct and balance the markets. However, if these rational traders work for asset management firms and invest other people's money, their actions will be heavily scrutinised. If they engage in arbitrage and the prices remain unbalanced for a while, the clients may be unhappy and the trader may have to unwind the position at a loss. Therefore there is a limit to the arbitrage that the trader can engage in.