Arbitrage opportunities may stay persistently unexploited
Limits to arbitrage
Carrying out arbitrage is not always costless: information is costly, trading is costly, obvious profits are reality risky (see financial crisis)
Investors
Are not rational, i.e., they do not maximize profits by exploiting price patterns
"no free lunch"
Doesnot imply "prices are right"
Mispriced assets
There are strategies (portfolios) that may correct the mispricing, but they are often very risky
Risk-averse rational investors may be unwilling to put such risky strategies in place, allowing the mispricing to survive
Lack of short selling
May be explained by loss aversion
Value function u(x)
Increasing in x, concave for gains (x > 0), convex for losses (x < 0), has a kink at the origin, factor λ represents loss aversion
Loss Aversion
The segment of the value function curve representing losses is steeper than that representing gains, reflecting the fact that for the representative individual, losses hurt much more than commensurate gains help
Despite the positive expected value, most people find this lottery unappealing because the psychological cost of losing £100 is greater than the psychological gain of earning £150
Implication of loss aversion for utility theory
Decisions in the face of uncertainty are path dependent
If an individual gains £500 and then loses £500, traditional wealth-based utility theory would predict nochange in happiness, but under prospect theory, the individual would feel an overall loss in happiness if the reference point was reset to the wealth level after the gain
