Arbitrage Crashes and the Speed of Capital

Abstract

The imminent failure of large Wall Street prime brokerage firms during the 2008 financial crisis caused a sudden and dramatic decrease in the amount of financial leverage afforded hedge funds. This decrease in financing resulted from the ex post asymmetrical payoff to rehypothecation lenders – the ultimate providers of financing, through prime brokers, to hedge funds. Seemingly long-term debt capital became short-term capital creating a large mismatch in the duration of arbitrage opportunities on the left-hand side of arbitrageurs’ balance sheet and liabilities on the right-hand side. A primary consequence of this withdrawal of financing was the inability of hedge funds involved in relative-value trades to maintain prices of substantially similar assets at substantially similar prices. The magnitudes of these mispricings, and the time required to correct them, provide an indication of the role played by arbitrageurs in maintaining rational prices during normal times.

Keywords: Limited Arbitrage, Financial Crisis