Entrepreneurship, Arbitrage, and Capital
| Peter Klein |
Over the years I’m increasingly convinced that Israel Kirzner’s metaphor of entrepreneurship as costless discovery — a form of arbitrage, exploiting differences between actual prices and their Walrasian equilibrium values — is a misleading way to think about entrepreneurship. Emphasizing knowledge, the awareness of facts that other market participants do not possess, the metaphor leads our attention away from action, the employment of scarce means to achieve economic ends. I’ve argued in a series of papers (1, 2, 3) that opportunity exploitation, not opportunity discovery, drives the market process.
A key problem for the Kirznerian metaphor is that entrepreneurship does, in practice, involve capital investment, despite Kirzner’s insistence that “pure entrepreneurship” does not require ownership of resources. (As Joe Salerno reminds us, favorable reviews of Kirzner’s Competition and Entrepreneurship by Austrians Murray Rothbard, Henry Hazlitt, and Percy Greaves all pointed to the separation of entrepreneurship and property ownership as the lone weakness in Kirzner’s otherwise excellent exposition.) But what about financial-market arbitrage, an example often cited in the Kirznerian literature? Isn’t arbitrage an example of costless discovery of pure profit? Doesn’t the arbitrageur operate without capital?
Actually, real-world arbitrage does not resemble Kirznerian alertness at all. Brad DeLong recently reminded me of Shleifer and Vishny’s important 1997 Journal of Finance paper on arbitrage. Write Shleifer and Vishny:
Theoretically speaking, . . . arbitrage requires no capital and entails no risk. When an arbitrageur buys a cheaper security and sells a more expensive one, his net future cash flows are zero for sure, and he gets his profits up front. . . . [But] the textbook description does not describe realistic arbitrage trades. . . .
Even the simplest realistic arbitrages are more complex than the textbook definition suggests. Consider the simple case of two Bund futures contracts to deliver DM250,000 in face value of German bonds at time T, one traded in London on LIFFE and the other in Frankfurt on DTB. Suppose for the moment, counter factually, that these contracts are exactly the same. Suppose finally that at some point in time t the first contract sells for DM240,000 and the second for DM245,000. An arbitrageur in this situation would sell a futures contract in Frankfurt and buy one in London, recognizing that at time T he is perfectly hedged. To do so, at time t, he would have to put up some good faith money, namely DM3,000 in London and DM3,500 in Frankfurt, leading to a net cash outflow of DM6,500. However, he does not get the DM5,000 difference in contract prices at the time he puts on the trade. Suppose that prices of the two contracts both converge to DM242,500 just after t, as the market returns to efficiency. In this case, the arbitrageur would immediately collect DM2,500 from each exchange, which would simultaneously charge the counter parties for their losses. The arbitrageur can then close out his position and get back his good faith money as well. In this near textbook case, the arbitrageur required only DM6,500 of capital and collected his profits at some point in time between t and T.
Even in this simplest example, the arbitrageur need not be so lucky. Suppose that soon after t, the price of the futures contract in Frankfurt rises to DM250,000, thus moving further away from the price in London, which stays at DM240,000. At this point, the Frankfurt exchange must charge the arbitrageur DM5,000 to pay to his counter party. Even if eventually the prices of the two contracts converge and the arbitrageur makes money, in the short run he loses money and needs more capital. The model of capital-free arbitrage simply does not apply. If the arbitrageur has deep enough pockets to always access this capital, he still makes money with probability one. But if he does not, he may run out of money and have to liquidate his position at a loss.
In reality, the situation is more complicated since the two Bund contracts have somewhat different trading hours, settlement dates, and delivery terms. It may easily happen that the arbitrageur has to find the money to buy bonds so that he can deliver them in Frankfurt at time T. Moreover, if prices are moving rapidly, the value of bonds he delivers and the value of bonds delivered to him may differ, exposing the arbitrageur to additional risks of losses. Even this simplest trade then becomes a case of what is known as risk arbitrage. In risk arbitrage, an arbitrageur does not make money with probability one, and may need substantial amounts of capital to both execute his trades and cover his losses. Most real world arbitrage trades in bond and equity markets are examples of risk arbitrage in this sense. Unlike in the textbook model, such arbitrage is risky and requires capital.
Shleifer and Vishny are primarily concerned with the agency relationship between arbitraguers — a “a relatively small number of highly specialized investors [who use] other people’s capital” — and the wealthy individuals, banks, endowments, and other investors who provide the necessary resources. My point here is simply that there is no such thing as costless discovery of profit opportunities, even in financial-market arbitrage. Profits are earned by those who put resources at risk — the basic idea of the Knightian “judgment” framework Nicolai and I have been developing. When we invoke the theoretical construct of the entrepreneur to explain the existence of profit (as distinguished from wages, rent, and interest), we must recognize that the entrepreneur is, in essence, a resource owner.