How Constraining Are Limits to Arbitrage?
57 Pages Posted: 22 Aug 2014
Date Written: June 18, 2014
We examine to what extent institutional frictions such as short-sale constraints deter entry into informational arbitrage ex ante and reduce informational efficiency ex post. We focus on small arbitrageurs who target hard-to-short companies with correspondingly high potential for overvaluation. Being price-takers, they cannot correct mispricing through trading. Instead, they reveal their information to the market in an effort to induce long investors to sell so that prices fall. As long as the information is credible, revealing it accelerates price discovery and so reduces noise trader risk. By implication, even extreme short-sale constraints need not constrain arbitrage, as is often assumed.
Keywords: Informational arbitrage, limits to arbitrage; short sale constraints; mispricing; short selling; activist short sellers; trading strategies; behavioral finance; market efficiency
JEL Classification: G12, G14, G23, G2
Suggested Citation: Suggested Citation