Annual Conference

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Investment Finance, Senior Fellows/Fellows

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May 2014

How Constraining Are Limits to Arbitrage?

Limits to arbitrage play a central role in behavioral finance. They interfere with arbitrage processes so that security prices can deviate from true values for extended periods of time. We show empirically that limits to arbitrage need not be binding even in settings characterized by extreme costs of information discovery and severe short-sale constraints. We report evidence of (risky) arbitrage correcting mispricing (and doing so profitably) in a setting in which shallow-pocketed “arbitrageurs” expend considerable resources identifying overvalued companies and then risk their own limited capital trading against the companies. The mechanism that allows the arbitrageurs to circumvent limits to arbitrage involves credibly revealing their information to the market, in an effort to induce long investors to sell so that prices fall. This simple but apparently effective way around the limits suggests that limits to arbitrage may not always be as binding as sometimes assumed.
Keywords: Limits to arbitrage, short sale constraints, mispricing, Short Selling, activist short sellers, trading strategies, Behavioral finance, market efficiency
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