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Overcoming limits of arbitrage: Theory and evidence

  • Hombert, Johan
  • Thesmar, David

Limits to arbitrage arise because financial intermediaries may face funding constraints when mispricing worsens. Using a model with limits to arbitrage, where we allow arbitrageurs to secure capital even in case of underperformance, we show that arbitrageurs that are more protected from withdrawals have more mean-reverting and volatile returns. Using data on hedge fund performance, we find robust support for these hypotheses: Funds with contractual impediments to withdrawals, and funds with performance-insensitive outflows, recover more quickly after a bad year and have more volatile returns. Our evidence is consistent with the idea that some hedge funds overcome the limits to arbitrage.

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Article provided by Elsevier in its journal Journal of Financial Economics.

Volume (Year): 111 (2014)
Issue (Month): 1 ()
Pages: 26-44

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Handle: RePEc:eee:jfinec:v:111:y:2014:i:1:p:26-44
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