Arbitrage Crashes: Lack of Capital or Market Segmentation?

Abstract

The predominant explanation for arbitrage crashes is a lack of investor capital to exploit mispricing. This paper shows that slow moving capital is only partly responsible for the 2005 and 2008 arbitrage crashes in the convertible bond market. Even when convertible bonds where under-priced, investors were still actively buying strictly dominated straight bonds from the same issuers. This finding suggests that market segmentation exaggerated the arbitrage crashes in the convertible bond market. Furthermore, it is possible to exploit the market segmentation in an essentially risk free long/short trading strategy providing positive abnormal returns. The strategy is profitable even after accounting for transaction cost.