relatively undervalued share and short the other. Table 1.1 summarizes the
risks facing the arbitrageur. Since one share is a good substitute for the
other, fundamental risk is nicely hedged: news about fundamentals should
affect the two shares equally, leaving the arbitrageur immune. Nor are there
any major implementation costs to speak of: shorting shares of either com-
pany is an easy matter.
The one risk that remains is noise trader risk. Whatever investor senti-
ment is causing one share to be undervalued relative to the other could also
cause that share to become even moreundervalued in the short term. The
graph shows that this danger is very real: an arbitrageur buying a 10 per-
cent undervalued Royal Dutch share in March 1983 would have seen it
drop still further in value over the next six months. As discussed earlier,
A SURVEY OF BEHAVIORAL FINANCE 9
Figure 1.1. Log deviations from Royal Dutch/Shell parity. Source: Froot and
Dabora (1999).
Table 1.1
Arbitrage Costs and Risks That Arise in Exploiting MispricingFundamental Noise Trader Implementation
Example Risk (FR) Risk (NTR) Costs (IC)
Royal Dutch/Shell ×√×
Index Inclusions √√×
Palm/3Com ××√