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Limited Arbitrage, Segmentation, and Investor Heterogeneity: Why the Law of One Price So Often Fails

There are numerous examples of assets with identical payout streams being priced differently. These violations of the law of one price result from two factors. First, investors have heterogeneous asset valuations so that if two groups of investors trade in segmented markets they are likely to set different prices because they have different expectations as to the value of the identical assets. Second, such discrepancies can only persist if arbitrage activities are limited. There appear to be two major limitations, short sales constraints and noise trader risk. Those assets facing short sales constraints have an asymmetric distribution of pricing violations because short sales constraints only bind when asset prices are too high. By contrast, assets facing noise trader risk have symmetric violation distributions because noise trader risk must be born by arbitrageurs both when prices are too low as well as too high.

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Paper provided by Vassar College Department of Economics in its series Vassar College Department of Economics Working Paper Series with number 56.

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Date of creation: Nov 2003
Date of revision:
Handle: RePEc:vas:papers:56
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  1. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
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  11. Flynn, Sean M., 2005. "The Portfolio Allocation Effects of Investor Sentiment about the Ability of Managers to Beat the Market," Vassar College Department of Economics Working Paper Series 77, Vassar College Department of Economics.
  12. Duffie, Darrell & Garleanu, Nicolae & Pedersen, Lasse Heje, 2002. "Securities lending, shorting, and pricing," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 307-339.
  13. Eli Ofek & Matthew Richardson & Robert F. Whitelaw, 2003. "Limited Arbitrage and Short Sales Restrictions: Evidence from the Options Markets," NBER Working Papers 9423, National Bureau of Economic Research, Inc.
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