## **Learning Outcomes**

This article explains market anomalies and the limits to arbitrage, including:

- Defining market anomalies within the context of the Efficient Market Hypothesis and standard asset‑pricing theory.
- Explaining why rational, risk‑averse arbitrageurs may be unable or unwilling to eliminate observed mispricings.
- Describing the main categories of investor constraints—regulatory, mandate-based, and risk‑management related—and linking them to persistent anomalies.
- Detailing how transaction costs, funding costs, margin requirements, and short‑selling frictions erode expected arbitrage profits.
- Analyzing key dimensions of arbitrage risk, such as noise‑trader risk, model risk, and liquidity risk, and their impact on convergence trades.
- Illustrating, through CFA‑style scenarios, how real‑world frictions can overturn the predictions of textbook, riskless arbitrage models.
- Highlighting common reasoning errors and exam pitfalls when evaluating whether an apparent anomaly can be profitably arbitraged in practice.
- Connecting limits to arbitrage with behavioral finance explanations for anomaly persistence, reinforcing their relevance across multiple CFA Level 3 topic areas for candidates.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand market anomalies and the practical limits to arbitrage, with a focus on the following syllabus points:

- Recognizing examples of market anomalies and their implications for efficient markets theory
- Describing the roles of investor constraints, funding limitations, and transaction costs in creating barriers to arbitrage
- Explaining arbitrage risk and why it may deter rational arbitrageurs from acting
- Evaluating the persistence of anomalies in light of real-world frictions and risks
- Applying concepts of behavioral finance and arbitrage constraints to explain deviations from market efficiency

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is meant by a 'market anomaly,' and how can it challenge the Efficient Market Hypothesis?
2. List two constraints that can prevent rational arbitrageurs from eliminating a pricing anomaly.
3. Why do arbitrageurs face risk when trading against apparent mispricing?
4. Explain why short-selling restrictions can sustain certain anomalies for longer than expected.

## **Introduction**

In theory, rational arbitrage should eliminate pricing anomalies in financial markets, ensuring efficiency. However, persistent anomalies suggest that real-world frictions limit this process. This article examines why arbitrage activity is often insufficient to correct mispricings by considering investor constraints, costs, and risks faced by arbitrageurs. Understanding these practical limits is essential for CFA candidates, as it is tested conceptually and through scenario-based questions.

> **Key Term: market anomaly**
> A pattern or regularity in asset prices or returns not predicted by accepted financial models, suggesting deviation from market efficiency.
>
> **Key Term: arbitrage**
> Simultaneous purchase and sale of equivalent assets to profit from price differences, typically with the expectation of near-riskless gain.

## THE LIMITS TO ARBITRAGE

While textbook arbitrage is often presented as costless and riskless, in practice it is rarely so. Various obstacles can prevent rational traders from fully exploiting mispricings, allowing anomalies to persist.

### Investor Constraints

Many investors face institutional or legal barriers that prevent them from acting on pricing anomalies:

- Regulatory restrictions (prohibitions on short selling in certain markets)
- Mandates or investment policy constraints (e.g., only being permitted to invest in a specific asset class)
- Risk management policies (limits on borrowing, drawdowns, or loss tolerances)

These constraints mean many anomalies remain uncorrected even when identified.

> **Key Term: investor constraint**
> A restriction—regulatory, institutional, or contractual—that limits an investor’s ability to freely transact or take desired portfolio positions.

### Transaction and Funding Costs

Arbitrage strategies typically require significant capital and entail costs, such as:

- Bid-ask spreads and brokerage commissions
- Borrowing costs when selling short
- Margin requirements and potential margin calls
- Funding risk, where arbitrageurs may not be able to meet cash calls if their position moves against them before convergence

These frictions reduce the expected profit from arbitrage trades and may render some strategies unattractive.

> **Key Term: transaction cost**
> Expenses directly or indirectly incurred when executing trades, including spreads, commissions, fees, and taxes.
>
> **Key Term: funding constraint**
> A limit on the amount of capital an arbitrageur can raise or maintain to support positions, increasing the risk of forced liquidation during adverse price moves.

### Arbitrage Risk ("Fundamental Risk")

For arbitrage to be effective, asset prices must converge within the arbitrageur's investment horizon. However, several risks can disrupt this:

- "Noise trader risk": Mispricing may worsen before it corrects, leading to interim losses for the arbitrageur.
- Model risk: The strategy may be based on incorrect assumptions about value or convergence.
- Liquidity risk: An arbitrageur may be unable to trade out of positions if markets seize up.

Unlike riskless textbook arbitrage, real-world arbitrageurs bear considerable risk that can deter aggressive exploitation of anomalies.

> **Key Term: arbitrage risk**
> The possibility that the price discrepancy used in the strategy will not correct, or will widen, within the arbitrageur's investment horizon, leading to losses.

## BEHAVIORAL FACTORS AND ANOMALY PERSISTENCE

Behavioral finance provides further explanation for why anomalies persist:

- _Investor psychology_ may cause herd behavior, framing effects, or overreaction, which sustain mispricings.
- _Limits to arbitrage_ magnify the effect of behavioral biases, as rational traders cannot freely correct dislocations.

### **Worked Example 1.1**

**A hedge fund identifies that a dual-listed company trades 3% higher on Exchange A than on Exchange B, net of fees. Why might the fund hesitate to arbitrage this pricing gap fully?**

> **Answer:**
> The fund could face funding constraints—if the mispricing widens, losses could force the fund to post margin or liquidate. Additionally, liquidity may be limited, short-selling may be restricted, and the cost of establishing and unwinding the strategy may exceed the expected profit. Arbitrage risk, if price convergence takes longer than anticipated, may outweigh the attractive headline return.

### **Worked Example 1.2**

**Suppose an investor recognizes a well-publicized 'calendar anomaly' (stocks regularly outperform in January) and attempts to profit. Why might the anomaly remain despite being widely known?**

> **Answer:**
> If institutional investors are unable to shift their allocations quickly due to mandates or operational limits and the transaction costs for frequent repositioning are high, the anomaly can persist. In practice, market frictions, regulatory rules, or collective reluctance to deviate from norms (e.g., career risk in asset management) can also cause the return pattern to continue.

### **Exam Warning**

> On the exam, avoid assuming that all pricing anomalies will disappear quickly. Just because a mispricing is identified does not mean arbitrage is practical, profitable, or without risk.

### **Revision Tip**

> Be ready to explain _specifically_ how particular constraints (e.g., high short-selling costs, liquidity limits) deter arbitrage in worked examples or written answers.

## **Summary**

Limits to arbitrage mean that market anomalies can persist far longer than standard theories predict. Costs, institutional constraints, and the risks of arbitrage strategies all act as barriers preventing rational traders from exploiting inefficiencies fully. Understanding real-world frictions and their behavioral implications is essential for explaining persistent anomalies and for tackling CFA questions on market efficiency.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define market anomalies and explain their challenge to market efficiency
- Identify and describe real-world investor constraints impeding arbitrage
- Recognize how transaction and funding costs reduce arbitrage profits
- Explain arbitrage risk and why anomalies may persist despite rational trading
- Illustrate with practical CFA-style examples how arbitrage limits sustain market anomalies

## **Key Terms and Concepts**

- market anomaly
- arbitrage
- investor constraint
- transaction cost
- funding constraint
- arbitrage risk

Market anomalies and limits to arbitrage - Constraints costs and arbitrage risk