Question

2) An investor believes he/she has identified an over-priced stock and is interested in shorting the stock. Explain what limits to arbitrage are and how they would apply to this specific situation.

Answer 1

Even though the stock could be truly overpriced as the investor has identified, the issue with shorting the stock is that the markets (and therefore this particular stock) could remain at high levels (exuberant) over long periods of time. The high stock prices could be driven by market sentiments rather than fundamentals. While the prices will correct over the long term - it may even take months and years. Therefore the investor will have to keep rolling over the expiry date for the put option till the time prices fall below break even. The transaction costs could be huge over a period of time and if borrowed money is involved, it becomes even more difficult and expensive.