Ch.18:A Survey of Behavioral Finance 1059 own money,but rather managing money for other people.In the words of Shleifer and Vishny (1997),there is "a separation of brains and capital". This agency feature has important consequences.Investors,lacking the specialized knowledge to evaluate the arbitrageur's strategy,may simply evaluate him based on his returns.If a mispricing that the arbitrageur is trying to exploit worsens in the short run,generating negative returns,investors may decide that he is incompetent, and withdraw their funds.If this happens,the arbitrageur will be forced to liquidate his position prematurely.Fear of such premature liquidation makes him less aggressive in combating the mispricing in the first place. These problems can be severely exacerbated by creditors.After poor short-term returns,creditors,seeing the value of their collateral erode,will call their loans,again triggering premature liquidation. In these scenarios,the forced liquidation is brought about by the worsening of the mispricing itself.This need not always be the case.For example,in their efforts to remove fundamental risk,many arbitrageurs sell securities short.Should the original owner of the borrowed security want it back,the arbitrageur may again be forced to close out his position if he cannot find other shares to borrow.The risk that this occurs during a temporary worsening of the mispricing makes the arbitrageur more cautious from the start. Implementation costs.Well-understood transaction costs such as commissions,bid- ask spreads and price impact can make it less attractive to exploit a mispricing. Since shorting is often essential to the arbitrage process,we also include short-sale constraints in the implementation costs category.These refer to anything that makes it less attractive to establish a short position than a long one.The simplest such constraint is the fee charged for borrowing a stock.In general these fees are small-D'Avolio (2002)finds that for most stocks,they range between 10 and 15 basis points-but they can be much larger;in some cases,arbitrageurs may not be able to find shares to borrow at any price.Other than the fees themselves,there can be legal constraints:for a large fraction of money managers-many pension fund and mutual fund managers in particular-short-selling is simply not allowed5. We also include in this category the cost of finding and learning about a mispricing, as well as the cost of the resources needed to exploit it [Merton (1987)].Finding 5 The presence of per-period transaction costs like lending fees can expose arbitrageurs to another kind of risk,horizon risk,which is the risk that the mispricing takes so long to close that any profits are swamped by the accumulated transaction costs.This applies even when the arbitrageur is certain that no outside party will force him to liquidate early.Abreu and Brunnermeier (2002)study a particular type of horizon risk,which they label synchronization risk.Suppose that the elimination of a mispricing requires the participation of a sufficiently large number of separate arbitrageurs.Then in the presence of per-period transaction costs,arbitrageurs may hesitate to exploit the mispricing because they don't know how many other arbitrageurs have heard about the opportunity,and therefore how long they will have to wait before prices revert to correct values.Ch. 18: A Survey of Behavioral Finance 1059 own money, but rather managing money for other people. In the words of Shleifer and Vishny (1997), there is “a separation of brains and capital”. This agency feature has important consequences. Investors, lacking the specialized knowledge to evaluate the arbitrageur’s strategy, may simply evaluate him based on his returns. If a mispricing that the arbitrageur is trying to exploit worsens in the short run, generating negative returns, investors may decide that he is incompetent, and withdraw their funds. If this happens, the arbitrageur will be forced to liquidate his position prematurely. Fear of such premature liquidation makes him less aggressive in combating the mispricing in the first place. These problems can be severely exacerbated by creditors. After poor short-term returns, creditors, seeing the value of their collateral erode, will call their loans, again triggering premature liquidation. In these scenarios, the forced liquidation is brought about by the worsening of the mispricing itself. This need not always be the case. For example, in their efforts to remove fundamental risk, many arbitrageurs sell securities short. Should the original owner of the borrowed security want it back, the arbitrageur may again be forced to close out his position if he cannot find other shares to borrow. The risk that this occurs during a temporary worsening of the mispricing makes the arbitrageur more cautious from the start. Implementation costs. Well-understood transaction costs such as commissions, bid– ask spreads and price impact can make it less attractive to exploit a mispricing. Since shorting is often essential to the arbitrage process, we also include short-sale constraints in the implementation costs category. These refer to anything that makes it less attractive to establish a short position than a long one. The simplest such constraint is the fee charged for borrowing a stock. In general these fees are small – D’Avolio (2002) finds that for most stocks, they range between 10 and 15 basis points – but they can be much larger; in some cases, arbitrageurs may not be able to find shares to borrow at any price. Other than the fees themselves, there can be legal constraints: for a large fraction of money managers – many pension fund and mutual fund managers in particular – short-selling is simply not allowed 5. We also include in this category the cost of finding and learning about a mispricing, as well as the cost of the resources needed to exploit it [Merton (1987)]. Finding 5 The presence of per-period transaction costs like lending fees can expose arbitrageurs to another kind of risk, horizon risk, which is the risk that the mispricing takes so long to close that any profits are swamped by the accumulated transaction costs. This applies even when the arbitrageur is certain that no outside party will force him to liquidate early. Abreu and Brunnermeier (2002) study a particular type of horizon risk, which they label synchronization risk. Suppose that the elimination of a mispricing requires the participation of a sufficiently large number of separate arbitrageurs. Then in the presence of per-period transaction costs, arbitrageurs may hesitate to exploit the mispricing because they don’t know how many other arbitrageurs have heard about the opportunity, and therefore how long they will have to wait before prices revert to correct values