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Slow Moving CapitalMotivationThis Paper: Empirically Instigate the Effect of Capital Outflow from ArbitrageursFindingsConvertible BondsConvertible Bond ArbitrageAnalysis 1: Convertible Bond Arbitrage Capital Outflows in 2005Redemptions in 2005Adjusted Holdings of Convertible BondsSlide 10Convertible Bond Arbitrage Returns and Market Price / Theoretical ValueInterpretationThe Case of AmaranthAnalysis 2: LTCM Blowup in 1998 - Implications for Convertible BondsConvertible Bond Arbitrage Returns and Market Price / Theoretical ValueAnalysis 3: Merger Arbitrage and the 1987 CrashMerger Arbitrage and the 1987 CrashSlide 18Conclusion: The Speed of ArbitrageSlow Moving CapitalMark MitchellCNH PartnersLasse Heje PedersenNYU, NBER, and CEPRTodd PulvinoCNH PartnersMotivation•Arbitrageurs normally provide liquidity by buying low and selling high•This requires capital•What happens if arbitrageurs loose capital? •Frictionless economy: –New capital arrives instantly, e.g. Lucas (1978)•Frictions matter:–Arbitrageurs depend on investors, Shleifer and Vishny (1997)–Margins may increase, Brunnermeier and Pedersen (2006)–Other traders lack infrastructure and information, Merton (1987)This Paper: Empirically Instigate the Effect of Capital Outflow from ArbitrageursStrategy: Identify markets in which we can estimate •“Fundamental value” and market price•Capital flows to and from natural liquidity providers•Actions and realized returns of liquidity providersWe Analyze Three Cases1. Capital outflow due to redemptions:–Convertible bonds, 20052. Capital outflow due to exit of large trader caused by losses in other markets–Convertible bonds, 19983. Capital outflow due to losses–Merger arbitrage, 1987FindingsLarge capital shocks can lead to:•Natural liquidity providers become liquidity demanders•New capital arrives only after months•Prices drop -- and rebound slowly•Realized returns initially negative, then turn positiveConvertible Bonds•Convertible bond: –Corporate bond + call option (+ more)•Theoretical value can be inferred from–Issuer stock price–Stock price volatility–Option-implied volatility–Risk-free interest rates–Credit spreadsConvertible Bond Arbitrage•Buy convertible bond if it trades at a discount•Short the issuers stock•Potentially:–Short risk-free bonds–Short non-convertible bonds (or buy CDS)–Short stock optionsAnalysis 1: Convertible Bond ArbitrageCapital Outflows in 2005•Natural liquidity providers: Convertible Bond Arbitrage Hedge Funds (HFs)•Capital outflows in 2005:–2005Q1: 20% capital redeemed–2005Q1 – 2006Q1: assets fell by half•Convert Arb HFs sold convertible bondsRedemptions in 2005Adjusted Holdings of Convertible BondsAdjusted Holdings of Convertible BondsQtrConvert Arb HFs Multi-strategy HFsConvert Mutual Funds2004-1 36.4 21.3 8.82004-2 38.1 18.8 8.92004-3 41.2 20.1 8.82004-4 40.4 19.8 8.92005-1 33.5 19.5 8.92005-2 32.5 25.2 8.52005-3 28.0 25.6 8.52005-4 26.3 26.9 8.12006-1 24.7 26.4 8.32006-2 22.6 25.9 8.42006-3 23.7 23.4Convertible Bond Arbitrage Returnsand Market Price / Theoretical ValueInterpretation•Prices drop and rebound•Price-to-fundamentals lowest around redemption notices (45 days before end of June and end of December)•Returns negative, then positive•Response by other traders:–Multi-strategy hedge funds–Mutual fundsThe Case of Amaranth•In 2005, Amaranth had–Losses in convertible bonds–Profits in energy trading–Overall profit and no capital problems•Decided to liquidate convertible bonds at time of significant cheapness•Collapsed in 2006 due to losses in energyAnalysis 2: LTCM Blowup in 1998- Implications for Convertible Bonds•Large hedge fund LTCM had losses due to Russian default, option positions, etc.•Had to liquidate large position in convertible bondsConvertible Bond Arbitrage Returnsand Market Price / Theoretical ValueAnalysis 3: Merger Arbitrage and the 1987 Crash•In a merger, “target” is bought at a premium.•At announcement, target increases in value, typ. 20-30%•But, there remains a “deal spread,” typically around 3%•Due to–Risk of deal failure–Selling pressure: Mutual funds sell after announcement•Merger arbitrageurs buy target–Stock deal: hedge by shorting acquirer–Cash deal: no hedgepricetarget price– target eoffer valu spread deal Merger Arbitrage and the 1987 CrashInterpretation•Oct. 14-16: U.S. House Ways and Means Committee proposed legislation •Oct. 19 (Black Monday) and 20: crash•Oct: 21-31: –Stock market rebounds–Congress backs off proposed legislation–But, prop traders kept selling•Berkshire Hathaway Annual Report (Warren Buffett):“During 1988 we made unusually large profits from [risk] arbitrage … the trick, a la Peter Sellers in the movie, has simply been ‘Being There.’ ”Conclusion: The Speed of Arbitrage•Findings–Liquidity providers can become demanders–New capital arrives slowly (new and old arbitrageurs)–Prices drop and rebound–Realized returns are initially negative and later turn positive and large•Conclusions:–Frictions matter–The process of arbitrage is far from instantaneous–Effect could be due (in part) to reduced market


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Chicago Booth BUSF 35150 - Slow Moving Capital

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