Overcoming Limits of Arbitrage: Theory and Evidence

35 Pages Posted: 3 Mar 2009 Last revised: 13 Mar 2013

See all articles by Johan Hombert

Johan Hombert

HEC Paris - Finance Department

David Thesmar

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA)

Multiple version iconThere are 2 versions of this paper

Date Written: October 20, 2011

Abstract

We present a model where arbitrageurs operate on an asset market that can be hit by information shocks. Before entering the market, arbitrageurs are allowed to optimize their capital structure, in order to take advantage of potential underpricing. We find that, at equilibrium, some arbitrageurs always receive funding, even in low information environments. Other arbitrageurs only receive funding in high information environments. The model predicts that arbitrageurs with stable funding should experience more mean reversion in returns, in particular following low performance. We test these predictions on a sample of hedge funds. Consistently with the model's implication, we find that hedge funds with lock-ups, or long redemption periods, tend to strongly over-perform, following low performance years.

Keywords: Limits of Arbitrage, Capital Structure, Market Efficiency

JEL Classification: G11, G32, G14

Suggested Citation

Hombert, Johan and Thesmar, David, Overcoming Limits of Arbitrage: Theory and Evidence (October 20, 2011). Available at SSRN: https://ssrn.com/abstract=1352285 or http://dx.doi.org/10.2139/ssrn.1352285

Johan Hombert

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France

David Thesmar (Contact Author)

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States
16172259767 (Phone)

Register to save articles to
your library

Register

Paper statistics

Downloads
266
Abstract Views
1,851
rank
113,327
PlumX Metrics