How Constraining are Limits to Arbitrage? Evidence from a Recent Financial Innovation

52 Pages Posted: 25 Jan 2014 Last revised: 13 Mar 2022

See all articles by Alexander Ljungqvist

Alexander Ljungqvist

Centre for Economic Policy Research (CEPR); Swedish House of Finance; European Corporate Governance Institute (ECGI)

Wenlan Qian

National University of Singapore - NUS Business School

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Date Written: January 2014

Abstract

Limits to arbitrage play a central role in behavioral finance. They are thought to interfere with arbitrage processes so that security prices can deviate from true values for extended periods of time. We describe a recent financial innovation that allows limits to arbitrage to be sidestepped, and overvaluation thereby to be corrected, even in settings characterized by extreme costs of information discovery and severe short-sale constraints. We report evidence of shallow-pocketed "arbitrageurs" expending considerable resources to identify overvalued companies and profitably correcting overpricing. The innovation that allows the arbitrageurs to sidestep 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 constraining as sometimes assumed.

Suggested Citation

Ljungqvist, Alexander and Ljungqvist, Alexander and Qian, Wenlan, How Constraining are Limits to Arbitrage? Evidence from a Recent Financial Innovation (January 2014). NBER Working Paper No. w19834, Available at SSRN: https://ssrn.com/abstract=2384293

Alexander Ljungqvist (Contact Author)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Wenlan Qian

National University of Singapore - NUS Business School ( email )

15 Kent Ridge Drive
Singapore 117592, 119245
Singapore
(65) 65163015 (Phone)

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