Correlation is not “arbitraged away” because there’s no inherent arbitrage in correlation. I think in your first example, you had in mind pairs trading where there is lagged correlation, or negative autocorrelation of the spread. In the second example, mortgages, what you’re saying’s just wrong.
An important aspect that you also omit to mention is that efficient market means the risk free expectation is the risk free rate. That does not mean that up and down are equally likely. A junk bond is much more likely to go up than down, only it’ll go up a little and down a lot. Returns can be skewed.
Last point, arbitrages are costly and often risky (the information available is not certain). You may not have more information than other people, but you may be less risk averse or you may be able to arbitrage at a lower cost.
Last point, arbitrages are costly and often risky (the information available is not certain). You may not have more information than other people, but you may be less risk averse or you may be able to arbitrage at a lower cost.
There is a googleable paper “the limits of arbitrage” by Shleifer which explains this concept in detail. Well worth the read
[From the original article] To get an excess return—a return that pays premium interest over the going rate for that level of riskiness—you need to know something that other market participants don’t, or they will rush in and bid up whatever you’re buying (or bid down whatever you’re selling) until the returns match prevailing rates.
There are other ways to get an excess return. They are all hard to do. Here is a partial list.
Exploit (or serve) someone else’s need for liquidity. People buying in Japan now may be doing this.
Taxation arbitrage. Provide trades that allow someone else to improve their after-tax position eg splitting a bond into coupon payments (tax-free to a non-profit) and capital gains (taxable at a concessional rate to other people).
Exploit agency problems. Eg If you can take the other side of a trade from someone who is trying to massage short term earnings regardless of longer term impact you can win. One example of this is trend following, where you mostly lose, but occasionally win big. The other side of the trade is the counter-trend trader, who wins month after month (and gets big bonuses for doing so), then their employer has a big loss. But hey, the trader already got his bonuses.
Exploit large numbers of stupid people such as dot.com investors. Sometimes there are so many of them they overwhelm the smart money. By getting your timing right you can exploit them. George Soros does this a lot.
Exploit impatience. See Shleifer’s article referenced above. For a fund manager, to win in the long term is useless, because his investors pulled their money long ago and his fund was closed down.
Correlation is not “arbitraged away” because there’s no inherent arbitrage in correlation. I think in your first example, you had in mind pairs trading where there is lagged correlation, or negative autocorrelation of the spread. In the second example, mortgages, what you’re saying’s just wrong.
An important aspect that you also omit to mention is that efficient market means the risk free expectation is the risk free rate. That does not mean that up and down are equally likely. A junk bond is much more likely to go up than down, only it’ll go up a little and down a lot. Returns can be skewed.
Last point, arbitrages are costly and often risky (the information available is not certain). You may not have more information than other people, but you may be less risk averse or you may be able to arbitrage at a lower cost.
There is a googleable paper “the limits of arbitrage” by Shleifer which explains this concept in detail. Well worth the read
There are other ways to get an excess return. They are all hard to do. Here is a partial list.
Exploit (or serve) someone else’s need for liquidity. People buying in Japan now may be doing this.
Taxation arbitrage. Provide trades that allow someone else to improve their after-tax position eg splitting a bond into coupon payments (tax-free to a non-profit) and capital gains (taxable at a concessional rate to other people).
Exploit agency problems. Eg If you can take the other side of a trade from someone who is trying to massage short term earnings regardless of longer term impact you can win. One example of this is trend following, where you mostly lose, but occasionally win big. The other side of the trade is the counter-trend trader, who wins month after month (and gets big bonuses for doing so), then their employer has a big loss. But hey, the trader already got his bonuses.
Exploit large numbers of stupid people such as dot.com investors. Sometimes there are so many of them they overwhelm the smart money. By getting your timing right you can exploit them. George Soros does this a lot.
Exploit impatience. See Shleifer’s article referenced above. For a fund manager, to win in the long term is useless, because his investors pulled their money long ago and his fund was closed down.