Working Paper: NBER ID: w12877
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: arbitrage; capital constraints; liquidity; convertible bonds; merger arbitrage
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 redemptions (G35) | decline in convertible bond prices (G12) |
| capital constraints (D24) | sell convertible bonds (G12) |
| capital redemptions (G35) | persistent drop in prices (E30) |
| forced liquidation of convertible bond positions (G33) | price declines (E30) |
| capital constraints during 1987 market crash (G01) | increased deal spreads (G24) |
| capital constraints during 1987 market crash (G01) | negative returns (G12) |