Analogies for Limited Arbitrage and Agent Distrust

Here in New York, people take their jaywalking pretty seriously. Let's call it a "limits to jaywalking" theory. There are a few exceptions. I have seen bicycle couriers do things that I thought were attempts at suicide, but I digress.

When presented with the opportunity, I will often do a diagonal jaywalk across a busy intersection. This has to be on a stale green in the direction I am walking, orthogonal to the cross. They are fairly easy to set up and decide upon, but the looks I get from pedestrians after finishing the move are similar to those I give to the apparently suicidal bicycle couriers.

What's the relevance of this? Hedge funds have a real problem these days acting on arbitrage opportunities because their marketing department's requirement that they be open ended (for competitive reasons, customers can withdraw their money whenever they want). This is referred to in the literature as limits to arbitrage. It's basically a trust problem. Hedge funds may identify an arbitrage (mispricing of equivalent assets), but these have a tendency to become more mispriced after the hedge fund takes a position as more noise traders enter the market. The hedge fund customer gets a performance statement in the mail (you lost money this month) and decides that the fund manager is incompetent and withdraws their funds to place them with a manager that has postive returns during each and every month. The hedge fund manager has to unwind their arbitrage position at a loss in order to redeem the customer's capital investment. This one of the reasons for the 1998 meltdown in Long Term Capital Management.

The only other analogy I can think of for this is based on professional experience (limits to refactoring?). A software engineer is placed on a project with some mess of old source code written by people that are long gone. To add insult to injury, the erstwhile engineers used to take freequent breaks from their work to inject exotic drugs in the bathroom of their employer. The new engineer has no existing trust relationship with the manager that hired her in apart from a few thumbs up from references and people that conducted interviews with her. The manager asks her to make a few minor feature enhancements in the project, and provides a two week deadline. She presents a proposal to rework some of the most sclerotic code in an effort to make other modifications down the road easier. The manager very tentatively agrees, and checks in every now and then to ask how things are going. The software engineer has a pale look, and the manager thinks about firing her. At the end of two weeks, the mods are complete and some of the byzantine code has been exorcised. Both manager and engineer are reluctant to plan any further sanitizing of the existing code.

If anyone can come up with another analogy from their own experience, please write it as a comment!

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