For as long as the freedom to deal across different markets has been in existence, investors have always taken advantage of slight differences in the price of a commodity, security, or currency across different markets to make a profit. While the making of profit is what every investor looks forward to, limits on arbitrage explain why it is impossible to always beat the cryptocurrency market, for instance, at all times. Here are a few things that you need to understand.
How Does it Work?
Rational traders, known as arbitrageurs, help to ensure that the price of commodities or securities follows the efficient market hypothesis (EMH). However, they do not get their way at all times because of the limits to arbitrage.
Whether it is in commodities, securities, or any other kind of market, arbitrageurs help to normalize the market by investing in markets where prices are well below what they ought to be. For instance, if a cryptocurrency investor notices an unusual drop in price in one market and decides to cash in, he or she expects that price will normalize within a given period in order to make a profit.
Unfortunately, should the price of cryptocurrency not rise as expected beyond the length of time the investor is capable of holding the investment, he or she would be forced to sell at a loss.
What Does it Do?
Despite the likely profit to be made, there is a limit to how much time an investor can wait for the price of the commodity invested in to reach the desired exit point. For this reason, arbitrageurs can only hope that things go according to plan.
But as most investors have learned, an unplanned lull in market prices can outlast the patience of deep-pocketed investors, really. As a result, limits to arbitrage are capable of putting an investor out of business, depending on how much investment is involved or compel investors to take a great loss when they close out at unfavorable positions.
Who Would Benefit From It?
Although the idea that markets can outlast the patience of seasoned investors who play a major role in maintaining the efficient market hypothesis (EMH), may sound bad, not every party loses out completely.
In scenarios where rational traders lose out, it tends to be the gain of volatility managed portfolios. It explains the reason for their abnormal returns. Just as in life, nothing is entirely a loss for everyone in the world of finance.
An efficient market hypothesis remains a driving force for cryptocurrency investors, among others. It explains why rational traders invest in markets with an unusually low price of a commodity in the hope of correcting them. Unfortunately for them, they have to deal with limits to arbitrage every once in a while. Where this is not the case, arbitrageurs will never make a loss or run out of business as can sometimes be the case.