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

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.

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