Alternative Investing
Arbitrage Crashes and the Speed of Capital
May 27, 2011
Topics - Alternative Investing Arbitrage
Modern finance theory rests on the ability of arbitrageurs to ensure that substantially similar assets trade at substantially similar prices. When prices of related assets diverge, arbitrageurs sell short the expensive asset and simultaneously buy the cheap asset. When the prices of the assets converge, arbitrageurs unwind their trades and generate risk-free profits. As long as arbitrageurs can borrow, they can turn even small pricing discrepancies between substantially similar securities into large profits. Although arbitrageurs may not cause absolute prices to equal fundamental values, they can ensure assets are priced correctly on a relative basis.
If arbitrageurs lose access to debt capital, they may be unable to force prices of similar assets to the same level. When this occurs, substantially similar assets can trade at wildly different prices. In this paper, we measure the relative pricing errors that occurred during the 2008 financial crisis, when arbitrageurs were unable to borrow and were therefore financially constrained.
We focus on arbitrage strategies involving corporate securities, including convertible debenture arbitrage, CDS–corporate debenture arbitrage, closed-end-fund arbitrage, merger arbitrage and Special Purpose Acquisition Company (SPAC) arbitrage. None of these is a true arbitrage strategy because the securities underlying the trades are merely related rather than nearly identical, but we contend the securities are related closely enough to provide an estimate of the relative mispricings arbitrageurs typical eliminate.
In addition to documenting the level of mispricings, we document the time required for capital to flow into the void left by arbitrageurs. Seemingly risk-free arbitrage opportunities offering extraordinary expected returns were available for several months after the 2008 financial crisis.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.