Slow Moving Capital
Mark Mitchell
CNH Partners
Lasse Heje Pedersen
NYU, NBER, and CEPR
Todd Pulvino
CNH Partners
Motivation
• 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 Arbitrageurs
Strategy: 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 providers
We Analyze Three Cases
1. Capital outflow due to redemptions:
–
Convertible bonds, 2005
2. Capital outflow due to exit of large trader caused by
losses in other markets
–
Convertible bonds, 1998
3. Capital outflow due to losses
–
Merger arbitrage, 1987
Findings
Large 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
positive
Convertible 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 spreads
Convertible 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 options
Analysis 1: Convertible Bond Arbitrage
Capital 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 bonds
Convert Arb HF Assets Under
Management ($B)
Redemptions in 2005
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0
2004-4 2005-1 2005-2 2005-3 2005-4 2006-1 2006-2 2006-3
Date
Source: Barclay Group
Adjusted Holdings of Convertible Bonds
45.0
40.0
35.0
30.0
Multi-strategy HFs
25.0
20.0
15.0
10.0
Convert Mutual Funds
5.0
Date
2006-3
2006-2
2006-1
2005-4
2005-3
2005-2
2005-1
2004-4
2004-3
2004-2
0.0
2004-1
Adj. Holdings of Convertible
Bonds (Billion $)
Convert Arb HFs
Adjusted Holdings of Convertible Bonds
Qtr
Convert Arb
HFs
Multi-strategy HFs
Convert
Mutual
Funds
2004-1
36.4
21.3
8.8
2004-2
38.1
18.8
8.9
2004-3
41.2
20.1
8.8
2004-4
40.4
19.8
8.9
2005-1
33.5
19.5
8.9
2005-2
32.5
25.2
8.5
2005-3
28.0
25.6
8.5
2005-4
26.3
26.9
8.1
2006-1
24.7
26.4
8.3
2006-2
22.6
25.9
8.4
2006-3
23.7
23.4
Convertible Bond Arbitrage Returns
and Market Price / Theoretical Value
1.10
1.05
1.00
1.00
0.95
0.98
0.90
Market Price/Theoretical Value
(left scale)
0.96
Date
0.85
Cumulative Return
Cumulative Return
(right scale)
200412
200501
200502
200503
200504
200505
200506
200507
200508
200509
200510
200511
200512
200601
200602
200603
200604
200605
200606
200607
200608
200609
Market Price / Theoretical Value
1.02
Interpretation
• 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 funds
The 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 energy
Analysis 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 bonds
Convertible Bond Arbitrage Returns
and Market Price / Theoretical Value
1.03
1.25
1.20
1.00
1.10
1.05
1.00
0.98
0.95
0.90
Market Price/Theoretical Value
(left scale)
0.95
Date
0.85
0.80
Cumulative Return
1.15
199712
199801
199802
199803
199804
199805
199806
199807
199808
199809
199810
199811
199812
199901
199902
199903
199904
199905
199906
199907
199908
199909
199910
199911
199912
Market Price / Theoretical Value
Cumulative Return
(right scale)
Analysis 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%
offer valu e – target price
deal spread 
target price
• 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 hedge
30%
1.20
Median Deal Spread
(left scale)
25%
Cumulative Return
(right scale)
15%
1.00
10%
0.90
5%
0.80
-10%
19871228
19871211
19871127
19871112
19871029
-5%
19871015
0%
0.70
0.60
Prop Desk Net Purchases
(left scale)
-15%
0.50
Date
Cumulative Return
1.10
20%
19871001
Median Merger Arbitrage Deal Spread, and
Net Purchases as % of Long Market Value
Merger Arbitrage and the 1987 Crash
Interpretation
• 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
liquidity