Overcoming Limits of Arbitrage: Theory and Evidence

Hombert, Johan; Thesmar, David

doi:10.2139/ssrn.1352285

Cited by 24 publications

(24 citation statements)

References 27 publications

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“…Overall, our results show that during the crisis of 2007-2008 stock market participation by hedge funds was dictated by capital limitations, market timing, and outside investment opportunities. The findings about the effects of capital constraints on hedge funds' trading patterns corroborate previous empirical results on the limits of arbitrage (Aragon and Strahan 2009, Hombert and Thesmar 2009, Comerton-Forde, Hendershott, Jones, Moulton, and Seasholes 2010, Hameed, Kang, and Viswanathan 2010. The evidence on selloffs appear to suggest that hedge funds destabilized the stock market during the crisis (in the line of the evidence of Lo 2007, Boyson, Stahel, andStulz 2008), and potentially symmetric to the finding that hedge funds ride bubbles in good times (Brunnermeier and Nagel 2004).…”

Section: Introductionsupporting

confidence: 87%

Hedge Fund Stock Trading in the Financial Crisis of 2007–2009

2011

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We study hedge fund trading in the stock market during the financial crisis of 2007-2008 and the surrounding years. We find that in the two quarters around the Lehman collapse (2008Q3-Q4) hedge funds reduced their equity holdings by about 29%, with nearly every fourth hedge fund cutting more than 40% of its equity portfolio in each quarter. We identify two main drivers of this behavior. First, in line with the presence of severe funding constraints, investor withdrawals and lender pressure account for about 78% of equity selloffs. These constraints are more binding for funds with low restrictions on investors' liquidity, and funds with low bargaining power vis-à-vis their brokers. Second, it appears that hedge funds reallocate capital to either cash, in an attempt to time the stock market, or other markets, in pursuit of more profitable investment opportunities. Finally, we find evidence for flight to quality (selloffs of high-volatility stocks) and static liquidity management (selloffs of high-liquidity stocks), which are consistent with distress selling driven by funding constraints.

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Section: Introductionsupporting

confidence: 87%

Hedge Fund Stock Trading in the Financial Crisis of 2007–2009

2011

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“…2 Our paper contributes to this literature by showing that hedge funds are heterogeneous and that the characteristics of their funding affect their strategies. By exploring the incentives associated with financial conglomerate affiliation, we complement earlier studies that have shown how hedge funds' share restrictions affect liquidity provision (Hombert and Thesmar, 2014) and long-term risky arbitrage (Giannetti and Kahraman, 2014).…”

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confidence: 96%

Financial Conglomerate Affiliated Hedge Funds: Risk Taking Behavior and Liquidity Transformation

Franzoni,

Giannetti

2017

SSRN Journal

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We show that financial-conglomerate-affiliated hedge funds (FCAHFs) have more stable funding and lower flow-performance sensitivity than other funds even though they are less likely to impose impediments on withdrawals. Arguably due to their privileged access to funding, during periods of financial turmoil, FCAHFs are able to take more risk and to purchase less liquid and more volatile stocks than other hedge funds. During good times, instead, FCAHFs expand their assets less than other funds and are less exposed to systematic risk factors. Thus, FCAHFs appear to perform a stabilizing function for the financial system even though they do not generate higher returns for their investors.

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“…The limits of arbitrage and its consequences in financial markets have been highlighted in prior empirical analysis and incorporated in a growing body of theoretical work (see, e.g., DeLong et al ., , b; Shleifer and Vishny, ; Abreu and Brunnermeier, , ; Liu and Longstaff, ; Kondor, , ; Stein, ; Hombert and Thesmar, ; Oehmke, ; Moreira, ; Makarov and Plantiny, ; Buraschi et al ., ; Ljungqvist and Qian, ; Edmans et al ., ; see also Gromb and Vayanos, for an excellent survey). These theoretical studies provide important and useful models regarding the equilibrium price–fundamentals relationship and the dynamic interactions between rational and, sometimes, ‘behaviourally biased’ agents.…”

Section: Hypothesis Developmentmentioning

confidence: 99%

Noise Momentum Around the World

Cai

Faff

Shin

2017

Abacus

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We argue that arbitrageurs will strategically limit their initial investment in an arbitrage opportunity in anticipation of further mispricing caused by the deepening of noise traders' misperceptions. Such 'noise momentum' is an important determinant of the overall arbitrage process. We design an empirical strategy to capture noise momentum in a two-period generalized error correction model. Applying it to a wide range of international spot-futures market pairs, we document pervasive evidence of noise momentum around the world.

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Overcoming Limits of Arbitrage: Theory and Evidence

Cited by 24 publications

References 27 publications

Hedge Fund Stock Trading in the Financial Crisis of 2007–2009

Hedge Fund Stock Trading in the Financial Crisis of 2007–2009

Financial Conglomerate Affiliated Hedge Funds: Risk Taking Behavior and Liquidity Transformation

Noise Momentum Around the World

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