Question

a) Discuss why financial costs may limit arbitrage activity, and describe the main financial costs faced by arbitrageurs.

b) Define ‘noise trader risk’, and explain why an arbitrageur may require a ‘noise trader risk premium’.

c) Discuss why and how an arbitrageur might short-sell a share. What may restrict their willingness or ability to do so?

d) With reference to the formerly dual-listed company Royal Dutch Shell, describe how an investor could devise an arbitrage strategy which involves no exposure to fundamental risk.

Answer 1

a) Arbitrage occurs when an investor can make a profit from simultaneously buying and selling a commodity in two different markets. For it to be sucessful the financial costs related to the process should be low or nil as the diffrence in prices of the two commodities is usually not high. Two major financal costs related to arbitrage process are:

1) Low/nil transaction cost in purchasing commodity/asset

2) Low/nil transaction costs in exchanging currency in case of currecy arbitrage

b) Noise trade risk refers to the risk of loss on investment which comes from a noise trader. A noise trader is someone who makes investment decision based on feelings such as greed or fear, rather than fundamentals or technicals of a stock or security. Presence of noise traders limit arbitrage opportunities. Once an arbitrager takes a position , noise traders may drive prices away from the fundamental value of the security, and the arbitrageur might be forced to invest more capital, which might not be available and forcing to liquidate position early. Thus in such cases the arbitrager needs a noise trade premium which covers the risk of noise traders in the market.

c) A hege fund strategy of convertible arbitrage is a trading strategy that involves buying a convertible security and selling the underlying common stock simultaneously. The aim of this strategy is to capitalize on pricing diffrences between the convertible and the stock. Thusin this case an arbitrager may sell the stock. But in certain markets there is restriction on short selling of stocks due to which the arbitrager may not be able to sell the stock

d) IN case of Dutch Shell, wwhich is listed in two exchanges, the arbitrager may sell the stock of the company in one market where the price is high and buy in another market (where the price is low) thus gaining an arbitrage profit in the process.