Limits of Arbitrage and Corporate Financial Policy

Abstract

We focus on an exogenous event that changes the cost of equity of the firm - the addition of its stock to the S&P 500 index - and we use it to test capital structure theories in a controlled experiment, where the effect of the index addition on the stock price is exogenous from a manager's point of view. We investigate how firms modify their corporate financial and investment policies as a reaction to the addition to the index. Consistent with both traditional theories and Stein's (1996) market timing theory, we find bigger increases in equity issues and investment - partly through more acquisitions - in response to bigger drops in the cost of equity. However, in the 24 months after the index addition, firms that issue equity and increase investment display negative abnormal returns and they perform worse than firms that issue but do not increase investment. This finding is consistent only with the market timing theory of Stein (1996) and supports a "limits of arbitrage" story in which stocks display a downward sloping demand curve and firms themselves act as "arbitrageurs" taking advantage of the window of opportunity provided by the stock price change around the S&P 500 index addition.

Keywords: Limits of arbitrage, S&P 500, market timing, capital structure

JEL Classification: G31, G32