Abstract
Will arbitrage capital flow into markets experiencing shocks, mitigating adverse effects on price efficiency? Not necessarily. In a dynamic model with privately informed capital-constrained arbitrageurs, price efficiency plays a dual role, determining both the profitability of new arbitrage and the ability to close existing positions profitably. An adverse shock to efficiency lengthens arbitrage duration, effectively reducing the amount of arbitrage capital available for new positions. If this falls below a critical mass, arbitrage capital flows out, amplifying the impact on price efficiency. This creates endogenous regimes: temporary shocks can trigger “hysteresis,” a persistent shift in price efficiency.
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