Thursday, April 5, 2007

The limits of arbitrage – explaining divergent market moves

With the strong deterioration in sub-prime lending, there has been a negative impact on the securitization market. Spreads are widening especially for lower rated tranches and the equity portion of deals. This strong negative reaction by markets to bad news is not isolated. There is a general tendency for price action to have stronger down moves versus a slower grind upward in price.

It is worth discussing the reasons why some markets may have significant market declines. While there may be clear economic reasons for a fall in value, markets can also decline because there are limits to the amount of capital that is available to take the other side of trades. We have seen a number of circumstances where a market sector has declines which are greater than what would be expected given economic conditions. Ex post, it always seem like there is an over reaction, but a different strain of thought for why markets may have strong negative reactions has been called the “limits of arbitrage” theory. This theory has also been used to explain a number of market anomalies.

Under the limits of arbitrage theory, steep price declines or market anomalies are associated with the fact that the marginal buyer requires specialized knowledge. Given operational knowledge may only be held by a limited set of market players, there will be a greater chance for an over reaction or for longer periods of dislocation for those markets which require unique analysis skills. When more specialized knowledge is required to make a decision, the chance there will be a shortfall of capital to take the other side of a trade increases. Similarly, if there is more uncertainty surrounding the reason for a price decline, that is, there is not a clear reason for the price move, then there will have to be a further decline to entice buyers to trade. The marginal buyer will have to have the skill to understand the uncertainty and the capital to act upon his beliefs.

Certain markets may exhibit greater volatility during adverse market periods. Some market anomalies may last longer than expected. This was described in the “The Limits of Arbitrage” by Andrei Shleifer and Robert Vishney in the Journal of Finance. This theory was recently explored empirically in the April 2007 issue Journal of Finance through analyzing specialized knowledge in the mortgage market, see “Limits of Arbitrage: Theory and Evidence from the Mortgage-Backed Securities Market” by Xavier Gabaix, Arvind Krishnamurthy, and Olivier Vigneron.

The marginal investors with special knowledge are also the very participants who may have already been holding these securities; therefore, there will be a negative wealth effect on why it may be hard to find the marginal buyer. These specialists may also be less diversified than other managers because of their unique knowledge. This further compounds the liquidity issue. If prices in the market for sub-prime securitization declines, there will be less capital available for marginal buying by those with good market knowledge. Their knowledge of the potential value is present, but they do not have the capital to invest. New buyers or capital has to be found. Time is necessary to stem the liquidity crisis.

The limit of arbitrage theory also presents asymmetrical information problems for some markets. If there are limited buyers for a specific type of structure, it may occur that all will have similar opinions about the market at the same time. More specialized knowledge may have less likelihood for diversification or heterogeneity of opinions about value. Additionally, when there is specialized knowledge there is the potential for adverse selection problems. Anyone who wants to sell a deal during declining economic times may be thought to have special knowledge about the adverse conditions. Buyers who believe that they do not have this knowledge would require greater compensation before they enter the market. This would also be true for new players who may perceive that they have less specialized knowledge about these markets.

In many market situations, there may not be just a shortage of capital. Markets with liquidity problems could be facing a knowledge shortfall, the ultimate capital.

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