Richard H Thaler - Misbehaving- The Making of Behavioral Economics (epub)

years, there were two kinds of shares of the merged company Royal Dutch Shell.
Royal Dutch shares traded in New York and the Netherlands, and Shell shares
traded in London. According to the terms of the merger agreement that created
this company in 1907, 60% of the profits would go to Royal Dutch shareholders
and 40% would go to Shell shareholders. The law of one price stipulates that the
ratio of the prices of the two classes of shares should be 60/40 or 1.5. But did the
two share prices always trade at that ratio? No! Sometimes the Royal Dutch
shares traded as much as 30% too low, and other times they traded as much as
15% too high. Noise traders appear to have particular difficulty with multiplying
by 1.5.
In this case, the smart trade is to buy whichever is the cheaper version of the
stock and sell the expensive version short. Unlike the case of Palm and 3Com,
both versions of the stock were widely traded and easy to borrow, so what
prevented the smart money from assuring that the shares traded at their
appropriate ratio of 1.5? Strangely, nothing! And crucially, unlike the Palm
example, which was sure to end in a few months, the Royal Dutch Shell price
disparity could and did last for decades.‡ Therein lies the risk. Some smart
traders, such as the hedge fund Long Term Capital Management (LTCM), did
execute the smart trade, selling the expensive Royal Dutch shares short and
buying the cheap Shell shares. But the story does not have a happy ending. In
August 1998, because of a financial crisis in Asia and a default on Russian
bonds, LTCM and other hedge funds started to lose money and needed to reduce
some of their positions, including their Royal Dutch Shell trade. But, not
surprisingly, LTCM was not the only hedge fund to have spotted the Royal
Dutch Shell pricing anomaly, and the other hedge funds had also lost money in
Russia and Asia. So at the same time that LTCM wanted to unwind its position
in Royal Dutch Shell, so did other hedge funds, and the spread moved against
them, meaning that the expensive version got more expensive. Within weeks,
LTCM had collapsed from this and other “arbitrage” opportunities that got worse
before they got better.
The LTCM example illustrates what Andrei Shleifer and his frequent coauthor
Robert Vishny call the “limits of arbitrage.” In fact, in a paper they published on
this topic in 1997, a year before these events occurred, they quite cannily
described a hypothetical situation much like what LTCM experienced. When
prices start to move against a money manager and investors start to ask for some
of their money back, prices will be driven further against them, which can cause
a vicious spiral. The key lesson is that prices can get out of whack, and smart
money cannot always set things right.