DP7212 Limits of Limits of Arbitrage: Theory and Evidence

Author(s):	Johan Hombert, David Thesmar
Publication Date:	March 2009
Keyword(s):	arbitrageur, capital structure
JEL(s):	G11, G14, G32
Programme Areas:	Financial Economics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=7212

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.