Overcoming limits of arbitrage: Theory and evidence |
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| Institution: | 1. HEC Paris, France;2. CEPR, United Kingdom;1. Santa Clara University, United States;2. Wilfrid Laurier University, Canada;1. Stanford University, Graduate School of Business, United States;2. MIT Sloan School of Management, United States;3. NBER, United States;1. Foster School of Business, University of Washington, WA 98105, United States;2. University of California – San Diego, Rady School of Management, CA 92093, United States;1. Department of Banking and Finance, University of Zurich, Switzerland;2. Swiss Finance Institute (SFI), Switzerland;1. Binghamton University, United States;2. CEPR, United Kingdom;3. Loyola Marymount University, United States;4. Graduate School of Business, Stanford University, 655 Knight Way, Stanford, CA 94305, United States;5. NBER, United States;1. The Wharton School, University of Pennsylvania, United States;2. NBER, United States |
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| Abstract: | Limits to arbitrage arise because financial intermediaries may face funding constraints when mispricing worsens. Using a model with limits to arbitrage, where we allow arbitrageurs to secure capital even in case of underperformance, we show that arbitrageurs that are more protected from withdrawals have more mean-reverting and volatile returns. Using data on hedge fund performance, we find robust support for these hypotheses: Funds with contractual impediments to withdrawals, and funds with performance-insensitive outflows, recover more quickly after a bad year and have more volatile returns. Our evidence is consistent with the idea that some hedge funds overcome the limits to arbitrage. |
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| Keywords: | Limits to arbitrage Hedge funds Capital structure |
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