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In praise of ketchup economics

By "ketchup economics" Professor Summers meant the study of relative prices. Ketchup economists, he said, have estimated that "two quart bottles of ketchup invariably sell for twice as much as one quart bottle of ketchup except for deviations traceable to transactions costs". Of course, there aren't really any ketchup economists, but financial economists are very similar. These, complained Professor Summers, "are concerned with the inter-relationships between the prices of different financial assets. They ignore what seems to many to be the more important question of what determines the overall level of asset prices."

However, these inter-relationships matter. To see why, let's look at the ketchup market. At Waitrose, a 700g bottle of Heinz tomato ketchup sells for £2 while a 460g bottle costs £1.75. You might perceive an arbitrage opportunity here. You could buy 23 of the bigger bottles for £46, tip the contents into 35 460g bottles and sell these for up to £61.25. That's a profit of up to £15.25 - a 33 per cent return on capital.

Except, you can't. Where can you find those 35 empty 460g bottles? How do you completely empty the 700g bottles without waste? How do you convince customers that what you're selling really is Heinz ketchup?

A moment's thought, therefore, tells us that what looks like an arbitrage opportunity is, in fact, no such thing. Those 700g bottles might look underpriced relative to the 460g ones. But you can't make a profit from this. And as far as I know, nobody does so.

The same is true in financial markets. Just because an asset looks underpriced does not mean you can make easy money by buying it.

This is most obvious for investment trusts, which often trade at a discount to net asset value. Such discounts mean that you could in theory buy shares in the trust and short-sell the stocks it holds and make a certain profit. In practice, though, we can't do this - which is why the discounts remain.

There are many reasons why you can't do so, most obviously that the trusts simply hold too many shares to short. Also, some stocks are hard to short-sell simply because it's difficult to find someone to lend them to you - and if they do lend them they might want them back before you've made a profit. As Lasse Heje Pedersen points out in Efficiently Inefficient, recall risk can be a big problem for short-sellers.

A further problem is that when you borrow a stock you have to post collateral or margin. If the stock you've shorted rises in price - even if only temporarily - you'll have to post more. This, said Andrei Shleifer and Robert Vishny in a classic study of the limits of arbitrage, means that "arbitrage is risky and requires collateral".

A great example of this came just a few months after they wrote that. The hedge fund Long-Term Capital Management (LTCM) thought there was an arbitrage opportunity in US Treasury bonds. Liquid bonds - the so-called 'on the run' stocks - seemed expensive relative to less liquid ones, so they shorted the liquid stocks and went long of the less liquid ones. But then Russia defaulted on its bonds, causing investors around the world to prefer liquid assets of all types to less liquid ones. LTCM faced big margin calls - so big that it went bust. Eventually, prices of the liquid bonds did fall. LTCM would have made big money if it had been able to maintain its position. But it couldn't. John Maynard Keynes never actually said "markets can remain irrational longer than you can stay solvent". But he should have done because this is both true and important - and a reason why arbitrage is dangerous.

There's another problem. To see it, consider the forex market. Back in the 1980s, economists thought that if one currency had a higher interest rate than another, it was expected to fall so that what you picked up in higher interest income you lost from currency depreciation. But then, they saw that this theory was wrong and that higher-yielding currencies didn't fall on average. This was the forward premium puzzle. It presented an arbitrage opportunity: traders could borrow a low-yielding currency (often Swiss francs or Japanese yen) and buy a higher-yielding one and make money; these were the so-called carry trades. However, the financial crisis of 2008 triggered a massive flight to safety, which saw the Swiss franc soar by 25 per cent against sterling in a few weeks. Years of small profits from interest rate pick-ups were wiped out. What looked like an arbitrage opportunity was, in fact, exposure to crash risk - the danger of sudden large losses.

Financial markets are therefore much like the ketchup market in that there are many obstacles to arbitrage: recall risk, pricing risk, liquidity risk, crash risk and so on. These obstacles mean that it is far harder to exploit apparent mispricings than you might imagine at first glance. Instead, as Mr Pedersen says, markets are "efficiently inefficient": you can only profit from mispricings with skill, effort and luck.

There's a message here not just for would-be arbitrageurs but for all equity investors. If a share seems underpriced, ask: why haven't other people exploited this fact? It might well be because it carries some hidden risks.

There's an ancient joke about two finance professors walking down the road. One says: "Look: there's a £10 note on the pavement." The other replies: "It can't be, else somebody would have picked it up." This joke misses the point - that there are, in fact, very few £10 notes on the pavement and certainly not enough for anyone to make a living by picking them up. There's no easy money to be made. The great thing about "ketchup economics" is that it warns us that apparent profit opportunities are often not genuine ones.