The Limits of Arbitrage

Robert Vishny, Andrei Shleifer

Research

27 Pages

This paper explains why professional arbitrage can fail when mispricing becomes most extreme. Because specialized managers depend on outside capital and recent performance, worsening prices can trigger withdrawals and forced selling, leaving markets least resilient precisely when attractive long term opportunities appear.

Key Takeaways

Three Period Model: The framework includes 3 periods and 3 participants: noise traders, arbitrageurs, and outside investors.
Losses Amplify Mispricing: Under Equation 9, prices can fall more than 1 for 1 when investor pessimism deepens and arbitrage capital retreats.
Value Requires Patience: Value stocks historically had only a 60% chance of beating the S&P 500 over 1 year, with stronger results over 5 years.
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