Arbitrage Trade and Pricing - Essay Example

Arbitrage Trade and Pricing + s The price of stock in the capital market tends to fluctuate depending on the imperfections of the market. At times, the price of a stock may be higher or lower than what it should be, in comparison derivative market. According to Bottazzi, Rin and Hellmann (2008, p.502), the arbitrageurs are synonymous with investing in low risk markets and they exploit the inefficiencies and imperfection in such markets to their advantage. Normally, investors monitor the behavior of the market and respond by buying stock in low risk markets and selling the same in the corresponding markets with different prices (Blume and Durlauf, 2007, p.3). The idea of arbitrage trade is to exploit the market opportunities by maximizing the profit. Notably, stock market prices seem to reflect the information at the disposal of the investors. Thus, efficient market hypothesis holds that market prices exhaustively show all the available information about the market. The idea behind this hypothesis is that investors are incapable of forecasting price change if all the market players have full information (Boyson, Jean, and Jan, 2012, p.3). In this case, no one would take advantage of the inefficiencies and imperfections in the markets. The presence of information to all the market players eliminates deviation of fundamental values. The expectations of the analysts often send the market into imbalance. A perfect example is a case where a section of the market players learns that earning in the stock market exceeds the analyst expectation. The investors will respond by buying the stock for speculation purposes. However, the presence of full information about the stock behavior among the market players renders speculative pricing worthless. The influence of the stock prices on the economy is a central phenomenon for debate. The influence of stock prices is evident when there is bubble in the stock market. Wide spread mispricing would makes it difficult for the arbitrageurs to restore the value to fundamentals (Coval and Erik, 2007, p.489). In most instances, mispricing emerges and spread fast across different sectors and securities. The product of this development is failure of the market to maintain the fundamental value. The arbitrage argument emphasize that companies should take the advantages of the overvalued stock because such moves often benefit the current shareholders (Frazzini and Lasse, 2012, p.5). Whereas the current shareholders would benefit, the effect of this development has ripple effect the economy. Nagel (2012, p.2016) believes that selling overvalued stock as well as investing the proceeds of such market activity amounts to destruction of value because the additional investments tends to set the marginal product of the capital below the maximum level. While old shareholders would be selling the stock at high prices the new shareholders, come in with the overrated value. The overrating of the shares limits the company’s ability to invest the stock in businesses that would generate positive income. The shareholders that buy the overrated shares can only make profit if they sell the same stock at overrated values. The situation seems to worsen the condition of the new shareholders because they are paying high prices for stakes in companies are incapable of selling their shares in high value end markets. In essence, this development creates an artificial imbalance for value in the stock market. Depending on the market response to the overvalued stock, the situation can create economic bubbles. Literature about investor behavior in the stock market seems to focus on arbitrageurs’ response to information. Much studies seem to focus on investors rush to buy stocks and circumstances surrounding such actions (Greenwood and Nagel, 2009, p. 241) Researchers have demonstrated that market bubbles influence the investment of a firm in the same way as investment influences the market bubbles (Gonzalez and James, 2007, p.42). Market bubbles results from over valuation of stock followed by rush investment on the overvalued stock then the investment of the overvalued stock fails. In this case, the overvalued stock would have a ripple effect to the economy of the market. The market would face the challenge of restoring the fundamental values because such attempts would elicit crush of the market. Arguably, this situation tends to make arbitrage trade very risky because it rest on speculation and negative change in market factors would elicit crush in investment. Some authors argue that managers have conflicting incentives when it comes to selling overvalued stock (Wang, Wang, and Zhang, 2012, p. 285). Naturally, the managers would not want to disappoint the shareholders by investing in the low-end markets. This situation tends to leave the managers with a few options for investing the overvalued stock. The most probable choice of investing this stock is cash interest bearing securities. However, some critics seem to cite the danger in such move by suggesting that investors may set the stock price above the fundamental value if they learn that firms are using the proceeds for other purposes other than capital acquisition. In this case, the response of the market would elicit economic bubbles in the same way, as investor’s actions would do. Hertzel and Li (2010, p.936) insist that economic bubble is a product of over valuation of the stock market followed by a crush of that market. However, the rush and such response to the market would not occur if all the market players have the same information. The efficient market hypothesis seems to hold that rational arbitrageur would make investment in such market thus the effects of overvaluation of the stock would not occur. The internet stock bubble has received a considerable volume of criticism. Some analysts have sought to use the behavior of the investors in the internet stock market in explaining arbitrageurs’ behavior. Brunnermeier and Nagel (2013, p.2014) note that investment in the internet market often attracts investors who are certain about their ability to forecast the market. Multiple factors contributed to the internet bubble. The factors range from overconfidence, limited asset float and the constraint brought to the market by short sale. Shive and Hayong (2012, p.2018) noted that a number of researchers concluded that the irrational behavior of the investors permeated the internet bubble. Lack of rational choices clouded the vision of the investors thereby plunging the market into perfect stock imbalance (Fong, Lean, and Wong, 2008, p. 301). Over valuation of the internet stock elicited rush investment then the market crushed. Largely, whereas the old shareholders made profits out of the sale of the overvalued stocks, firms were incapable of investing the overvalued stock in securities that would give a return on the value invested (Brunnermeier and Nagel, 2013, p.2019). The irrational confidence of the investors has both negative and positive impact on the firm as well as the market. First, the irrational confident investors may propagate market bubbles when their investments crush. Buying overvalued stock exposes investors to making losses because investing the overvalued stock is usually a big problem (Shive and Hayong, 2012, p. 227). Second, the action of the irrational confidence investors may be positive if their predication about the stock market happens. Notably, when the market behaves as anticipated by the irrational confidence investors, no imbalances would occur in terms of investing the overvalued stock. Thus, the market would not experience any ripple effects. Theories of risk preferences tend to explain a set of investor behavior and their influence in the stock market. The expected utility is the common approach used in forecasting the market. However, risk preferences tend to depend on individual choices. The prospect theory holds that the investors tend to focus on wealth changes (Ben-David, Francesco, and Rabih, 2012, p.3). The essence of investing is to gain some change of wealth. The choice to invest in uncertain market seems to cement the proposition of the prospect theory. Gains in the market would elicit rush in investment because the investors would be anticipating to take advantage of such situation. Studies show that investors would wish to avoid risks after experiencing losses than after gaining from the market (Aragon, 2007, p.45). The behavior of risk aversion and risk seeking has the propensity to affect the overall behavior of the stock market. For instance, the technology bubble was a product of risk seeking as opposed to risk aversion. The investors were confident that the overvalued stock would fetch high prices when invested. Nevertheless, the market crushed following the failure of the stock market to respond to the anticipation of the investors. As the forces attempts to restore the overvalued stock to the fundamental value, the investors tend to make losses (Aragon and Spencer, 2012, p.440). If large of the investors had invested in the failing stock then the whole economy would experience the bubble. The flow of information in the market often influence the response exhibited by the rational arbitrageur. Hedge funds have the tendency of reporting return data before the listing the dataset in the stock market (Campbell and Frye, 2009, p. 276). The strong performance tends to influence the investors into believing that the stock can perform hence the rush to buy such stock as evident in arbitrage trade. In this case, the response pattern of the arbitrageur tends to influence the imbalance in the stock market. However, the availability of information among the investors tends to limit the idea of speculation because every investor has the information needed by the market players. Blume and Durlauf (2007, p. 3) argue that during bubbles investors often base their decision to buy not only what they believe they are worth, but what other investors believe they are worth. They tend to divorce the valuation of the market from fundamentals because the urge to make profit tend to override the decision to limit the risk. The return on venture capital investment often depends on the stock market valuation. The venture capital investment tolerate under pricing when the market analyst have under predicated the value of the stock (Fong, Lean, and Wong, 2008, p. 289). In such situations, the arbitrageurs tend to rush into buying the stock for speculation purposes. However, rational arbitrageurs would consider the circumstances in the market before rushing into buying the stock. Many authors agree that misevaluation of stock permeates arbitrage trade because it allows the investors to speculate and sell their shares in high-end markets. Overreaction often pushes the stock prices beyond rational market value (Chi and Gupta, 2009, p. 1662). Notably, only rational arbitrageurs are capable of bringing stock prices back to their rational value. Whereas this development tends to prove the proposition that, what goes up would eventually come down and vice versa, overvaluation of stock may create pronounced market bubbles if many investors rush into buying the overrated stock in anticipation of investment, but fails to realize the same. In conclusion, rational arbitrageurs tend to limit deviation of the stock value for sustained periods because full information about the market exists. The irrational behavior of investors is the recipe of market bubbles. Although the managers may sell the stock of their companies when overrating of the stock occurs, the move would only benefit the current shareholders, but expose the new shareholders to losses. Investing the overrated stock is a challenge to the managers because they would not be willing to sell the same at losses. On the contrary, efficient markets tend to have uniform information an aspect that renders speculation impotent. 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