Abreu and Brunnermeier

Definition

Abreu and Brunnermeier refer to the influential work by economists Miguel Abreu and Markus Brunnermeier, which discusses how limits to arbitrage can prevent market participants from correcting mispriced assets. Their research highlights the interaction between fundamental value and investor behavior, emphasizing that even rational investors may refrain from arbitraging due to risk factors, such as uncertainty or potential losses.

5 Must Know Facts For Your Next Test

1. Abreu and Brunnermeier’s work focuses on how limits to arbitrage arise from market frictions and behavioral biases, which can lead to persistent mispricing in financial markets.
2. Their model illustrates that even when rational investors identify mispriced assets, they may not act on these opportunities if the risks of doing so are deemed too high.
3. The authors emphasize the role of investor sentiment and feedback loops, showing how collective behavior can exacerbate price deviations from fundamental values.
4. This research has significant implications for understanding financial bubbles and crashes, as it explains why prices can diverge from intrinsic values for extended periods.
5. Abreu and Brunnermeier’s insights have become foundational in behavioral finance, bridging traditional finance theories with psychological influences on investment decisions.

Review Questions

• How do Abreu and Brunnermeier explain the reasons behind limits to arbitrage in financial markets?
  • Abreu and Brunnermeier explain that limits to arbitrage occur due to market frictions, such as transaction costs, funding constraints, and behavioral biases among investors. They argue that rational investors may recognize mispriced assets but choose not to exploit these opportunities because the associated risks are too high. This creates a scenario where mispricing can persist over time, impacting overall market efficiency.
• Discuss the implications of Abreu and Brunnermeier's findings on market efficiency and investor behavior.
  • Abreu and Brunnermeier's findings challenge the traditional view of market efficiency by demonstrating that rational behavior can be hindered by psychological factors and external constraints. Their research suggests that markets may not always reflect all available information accurately due to investor sentiment and risk perceptions. This has significant implications for how we understand market dynamics, particularly during periods of irrational exuberance or panic.
• Evaluate how Abreu and Brunnermeier's model can be applied to understand financial crises and bubbles.
  • Abreu and Brunnermeier's model provides a framework for understanding financial crises and bubbles by illustrating how investor behavior can lead to prolonged periods of mispricing. When collective investor sentiment drives prices away from fundamental values, the risks associated with arbitraging these discrepancies increase. This feedback loop can create a situation where bubbles inflate until they burst, leading to significant market corrections. By analyzing these patterns, their work helps explain why some financial crises occur despite the presence of rational actors in the market.

Related terms

Arbitrage:

The practice of taking advantage of price differences in different markets for the same asset to generate profit without risk.

Behavioral Finance: A field of study that examines how psychological factors influence investors' decisions and market outcomes.

Market Efficiency:

The concept that asset prices reflect all available information at any given time, making it impossible to consistently achieve higher returns than the average market return.