Weekly Digest

Limits to sushi-arbitrage

Lorenzo La Posta

11 June 2018

The Efficient Markets Hypothesis implies that as soon as a mispricing of certain assets appears, arbitrageurs would exploit this inefficiency and bring the assets back to their equilibrium prices. However, this is sometimes prevented by structural and behavioural barriers; hence some arbitrage opportunities manage to survive much longer than they theoretically should.

Once a week, I have sushi for lunch. The shop near my office sells an underpriced box with 3 nigiri and 4 uramaki for £4 and a overpriced box with 6 nigiri or 6 uramaki for the same price. This presents a clear arbitrage opportunity: I could buy 2 underpriced boxes (thus having 6 nigiri, 8 uramaki) for £8, redistribute 6 nigiri in one box, 6 uramaki in another box and sell these two for £4 each, leaving me with 2 uramaki for no cost. So why am I not exploiting this arbitrage opportunity, given that in theory I should be able to? The single most important reason is that in practice I would not be able to sell the overpriced boxes at their shop-price of £4 each, simply because I am not a sushi shop. People would require a discount on these products to compensate for my lower trustworthiness and this would most likely outweigh the harvestable profit.

As much as this is an isolated story, it is representative of the very well-known limits to arbitrage in today’s financial markets.

The first and best-known limit is from the bid-ask spread: the higher it is, the more expensive trading a certain pair will be. Once trading costs exceed the potential gain, no arbitrageur will be willing to push the price back to its equilibrium price and the inefficiency will persist (as with  my sushi-arbitrage). Thus, very illiquid markets will generally have more unexploitable opportunities than high-volume high-liquidity markets such as large-cap equities or currencies. Secondly, given that arbitrageurs are sometimes required to short-sell an asset, the borrowing costs on the short position also affect the total profit-and-loss profile of the transaction and these might outweigh the potential gain. Finally, stronger limits to arbitrage include outright bans on short-selling or regulations preventing specific types of investors from accessing certain markets.

In addition, exploiting an arbitrage opportunity can be extremely dangerous as investors are generally unable to bear adverse market movements for prolonged periods of time. A famous quote from the economist John Keynes states that “Markets can remain irrational longer than you can remain solvent”. The clearest example of it is Long-Term Capital Management, a former leading hedge fund who in 1998 fell victim of a prolonged period of market irrationality. They had a highly leveraged exposure to the spread between certain bonds that in theory was supposed to narrow (it did, eventually); sudden political turmoil and panicking investors caused the spread to widen even more and eventually margin calls required LTGM to close their position and suffer extreme losses.

The main conclusion from all this is that arbitrage opportunities are easy to spot but hard to exploit. Despite their seemingly risk-free features, investors should be aware of the potentially large risks that arbitrage strategies carry before building any type of exposure to them. Furthermore, barriers and limitations make these market inefficiencies more persistent than expected, while concurrently creating an opportunity for active managers willing (and able) to bear such risks in a controlled and effective manner.

Download the above article >