Limited arbitrage in equity markets

Nagel, Stefan (2003) Limited arbitrage in equity markets. Doctoral thesis, University of London: London Business School.

Abstract

This dissertation analyses limits to arbitrage in equity markets. Chapter 2, "Limits to Arbitrage: A Survey of Theory and Evidence", provides a survey of the existing literature. In contrast to efficient markets theory, limits to arbitrage theory argues that the bounds imposed on prices by the forces of rational speculation can be rather wide, due to the risks and costs faced by arbitrageurs in imperfect capital markets. I discuss and structure recent theoretical and empirical developments in this field. Chapter 3, "Hedge Funds and the Technology Bubble", (co-authored with Markus K. Brunnen-neier) examines the behavior of sophisticated speculators (hedge funds) during the Technology Bubble 1998-2000. We find that the portfolios of hedge funds were heavily tilted towards (overpriced) technology stocks while the bubble was growing. This does not seem to be the result of unawareness of the bubble: At an individual stock level, hedge funds reduced their holdings before prices collapsed. Our findings are consistent with models in which rational investors can find it optimal to ride bubbles because of predictable investor sentiment and limits to arbitrage. In Chapter 4, "Short Sales, Institutional Investors, and the Book-to-Market Effect", I investigate whether the book-to-market (B/M) anomaly persists in the presence of sophisticated arbitrageurs because of short-sale constraints. Using institutional ownership and large stock lender ownership as proxies for the abundance of stock loan supply, I show that the B/M effect is driven by underperformance of difficult-to-short low B/M stocks. Moreover, return predictability effects attributed to short-sale constraints in prior research (breadth of ownership effect; loser momentum) most evident among stocks with low B/M and low institutional ownership, consistent with a common short-sale constraints explanation for these effects. Overall, this thesis shows that an analysis of incentives and constraints faced by sophisticated speculators delivers important insights into financial market phenomena.