Working Paper: NBER ID: w19834
Authors: Alexander Ljungqvist; Wenlan Qian
Abstract: Limits to arbitrage play a central role in behavioral finance. They are thought to interfere with arbitrage processes so that security prices can deviate from true values for extended periods of time. We describe a recent financial innovation that allows limits to arbitrage to be sidestepped, and overvaluation thereby to be corrected, even in settings characterized by extreme costs of information discovery and severe short-sale constraints. We report evidence of shallow-pocketed "arbitrageurs" expending considerable resources to identify overvalued companies and profitably correcting overpricing. The innovation that allows the arbitrageurs to sidestep limits to arbitrage involves credibly revealing their information to the market, in an effort to induce long investors to sell so that prices fall. This simple but apparently effective way around the limits suggests that limits to arbitrage may not always be as constraining as sometimes assumed.
Keywords: limits to arbitrage; behavioral finance; financial innovation; arbitrageurs; market reactions
JEL Codes: G02; G12; G14; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shallow-pocketed arbitrageurs (the arbs) (G19) | long investors (the longs) (G40) |
| long investors (the longs) (G40) | price corrections (D43) |
| shallow-pocketed arbitrageurs (the arbs) (G19) | market reactions (G10) |
| shallow-pocketed arbitrageurs (the arbs) (G19) | price adjustments (L11) |
| credible information revealed by arbs (J52) | long investors (the longs) (G40) |
| credible information revealed by arbs (J52) | price corrections (D43) |
| arbs' innovative approach (O36) | limits to arbitrage (G19) |