Slow Moving Capital

Unlike textbook arbitrageurs who instantaneously trade when prices deviate from fundamental values, real world arbitrageurs must overcome various frictions. For example, they often invest other people’s money, resulting in a principal/agent problem that is exacerbated in market downturns. Rather than increasing investment levels when prices dip below fundamental values, arbitrageurs may, in the face of capital constraints, sell cheap securities causing prices to decline further. As a result, mispricings can be large and can extend for long periods of time. We first study the convertible bond market in 2005 when convertible hedge funds faced large redemptions of capital from investors. These redemptions led to binding capital constraints for many funds, resulting in massive bond sales and, in many cases, fund liquidations. These sales reduced prices of convertibles relative to fundamental values, especially around redemption dates. While the group of multistrategy hedge funds that were not capital constrained increased their overall position, about half of these hedge funds actually acted as net sellers, consistent with the view that information barriers within a firm (not just relative to outside investors) can lead to capital constraints for trading desks with mark-to-market losses. We document similar patterns in the convertible bond market around the collapse of Long Term Capital Management (LTCM) in 1998. When LTCM incurred large losses on macroeconomic bets, the firm was forced to liquidate large convertible bond positions. These sales led to depressed valuations of convertible bonds Slow Moving Capital