Limits of Limits of Arbitrage: Theory and Evidence

45 Pages Posted: 7 Apr 2009

See all articles by Johan Hombert

Johan Hombert

HEC Paris - Finance Department

David Thesmar

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

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Date Written: March 2009

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 makes two easily testable predictions: first, arbitrageurs with stable funding should experience more mean-reversion in returns, in particular following low performance. Second, this larger mean-reversion should be lower, if many other funds have stable fundings. We test these predictions on a sample of hedge funds, some of which impose impediments to withdrawal to their investors.

Keywords: arbitrageur, capital structure

JEL Classification: G11, G14, G32

Suggested Citation

Hombert, Johan and Thesmar, David, Limits of Limits of Arbitrage: Theory and Evidence (March 2009). CEPR Discussion Paper No. DP7212. Available at SSRN: https://ssrn.com/abstract=1372532

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)

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