Overcoming Limits of Arbitrage: Theory and Evidence

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