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Slow Moving Capital

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Slow Moving Capital 

In this paper, the authors, Mark Mitchell, Lasse Heje Pedersen, and Todd Pulvino, show with three examples that real world frictions can constrain arbitrage capital:

-          The convertible bond arbitrage sell-off of 2005

-          The convertible bond arbitrage sell-off of 1998 due to the fall of the LTCM hedge fund

-          Risk arbitrage in October 1987 

The scenario is rather similar across the examples. After some large losses in arbitrage strategies, hedge funds face redemptions from investors and need to liquidate their holdings even though the held securities trade at a deep discount to fair value.

Proprietary trading desks of investment banks also face internal risk constraints and need to reduce their positions. In this situation, they are demanding liquidity instead of providing it: liquidity dries up.

The authors discuss the different examples in detail. Several multi-strategy hedge funds can reallocate capital to these strategies though normalization can take several months; many others however reduce their exposures, amplifying the fall in liquidity and fail to correct the mispricing. Markets can remain dislocated for a long period. 

Arbitrage capital moves slowly to these investment opportunities mainly because of these frictions:

-          Information asymmetry between investors and managers

-          Opportunity costs of unused resources waiting for infrequent investment opportunities

-          market illiquidity when the traditional providers of liquidity are also constrained 

The authors conclude that these constraints impede arbitrage capital. Interestingly, the recent losses in equity market neutral strategies seem to be another salient example of the impact of illiquidity and slow moving capital.     

Mitchell, Mark L., Pedersen, Lasse Heje and Pulvino, Todd C., "Slow Moving Capital" . American Economic Review, Forthcoming Available at SSRN: http://ssrn.com/abstract=958831

 

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