Limits to arbitrage is a

theory A theory is a rational type of abstract thinking about a phenomenon, or the results of such thinking. The process of contemplative and rational thinking is often associated with such processes as observational study or research. Theories may be s ...

financial economics Financial economics, also known as finance, is the branch of economics characterized by a "concentration on monetary activities", in which "money of one type or another is likely to appear on ''both sides'' of a trade".William F. Sharpe"Financial ...

that, due to restrictions that are placed on funds that would ordinarily be used by rational traders to

arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the ...

away pricing inefficiencies, prices may remain in a non-equilibrium state for protracted periods of time. The

efficient-market hypothesis The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted bas ...

assumes that whenever mispricing of a publicly traded

stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...

occurs, an opportunity for low-risk

profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit (real property), a nonpossessory intere ...

is created for rational traders. The low-risk profit opportunity exists through the tool of arbitrage, which, briefly, is buying and selling differently priced items of the same value, and pocketing the difference. If a stock falls away from its

equilibrium price In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the ( equilibrium) values of economic variables will not change. For example, in the st ...

(let us say it becomes undervalued) due to irrational trading (

noise trader A noise trader is a stock trader whose decisions to buy or sell are based on "factors they believe to be helpful but in reality will give them no better returns than random choices". These factors may include hype or rumor, which noise traders belie ...

s), rational investors will (in this case) take a

long position In finance, a long Position (finance), position in a financial instrument means the holder of the position owns a positive amount of the instrument. The holder of the position has the expectation that the financial instrument will increase in valu ...

while going

short Short may refer to: Places * Short (crater), a lunar impact crater on the near side of the Moon * Short, Mississippi, an unincorporated community * Short, Oklahoma, a census-designated place People * Short (surname) * List of people known as ...

proxy security Proxy may refer to: * Proxy or agent (law), a substitute authorized to act for another entity or a document which authorizes the agent so to act * Proxy (climate), a measured variable used to infer the value of a variable of interest in climate ...

, or another stock with similar characteristics. Rational traders usually work for professional money management firms, and

invest Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...

other peoples' money. If they engage in arbitrage in reaction to a stock mispricing, and the mispricing persists for an extended period, clients of the money management firm can (and do) formulate the opinion that the firm is incompetent. This results in withdrawal of the clients' funds. In order to deliver funds, the manager must unwind the position at a loss. The threat of this action on behalf of clients causes professional managers to be less vigilant to take advantage of these opportunities. This has the tendency to exacerbate the problem of pricing inefficiency. In perhaps the best known example, the American firm

Long-Term Capital Management Long-Term Capital Management L.P. (LTCM) was a highly-leveraged hedge fund. In 1998, it received a $3.6 billion bailout from a group of 14 banks, in a deal brokered and put together by the Federal Reserve Bank of New York. LTCM was founded in 1 ...

(LTCM) fell victim to limits-to-arbitrage, in 1998. The company had staked its investments on the convergence of the prices of certain bonds. These bond prices were guaranteed to converge in the long run. However, in the short run, due to the

East Asian financial crisis The Asian financial crisis was a period of financial crisis that gripped much of East Asia and Southeast Asia beginning in July 1997 and raised fears of a worldwide economic meltdown due to financial contagion. However, the recovery in 1998–1 ...

and the Russian government's debt default, panicked investors traded against LTCM's position, and so the prices that had been expected to converge were, instead, driven further apart. This caused LTCM to face

margin calls In finance, margin is the collateral that a holder of a financial instrument has to deposit with a counterparty (most often their broker or an exchange) to cover some or all of the credit risk the holder poses for the counterparty. This risk c ...

. Because the firm did not have enough money to cover these calls, they were compelled to close out their positions and to take great losses; whereas, ''if they had held their positions'', they then could have made significant profits.

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