Working Paper: CEPR ID: DP6117
Authors: Mark Mitchell; Lasse Heje Pedersen; Todd Pulvino
Abstract: We study three cases in which specialized arbitrageurs lost significant amounts of capital and, as a result, became liquidity demanders rather than providers. The effects on security markets were large and persistent: Prices dropped relative to fundamentals and the rebound took months. While multi-strategy hedge funds who were not capital constrained increased their positions, a large fraction of these funds actually acted as net sellers consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. Our findings suggest that real world frictions impede arbitrage capital.
Keywords: capital constraint; convertible bond; frictions; hedge funds; limits of arbitrage; liquidity; merger arbitrage; risk management; valuation
JEL Codes: G1; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital constraints (D24) | liquidity demand (E41) |
| liquidity demand (E41) | price declines (E30) |
| capital constraints (D24) | forced selling (G33) |
| forced selling (G33) | price declines (E30) |
| capital constraints (D24) | price declines (E30) |
| information barriers (D82) | price declines (E30) |
| liquidity provider constraints (E51) | prolonged periods of mispricing (G19) |