Limited arbitrage capital can force abandonment of even certain-profit trades

Evidence

If arbitrageurs are constrained by finite supplies of capital, even an arbitrage trade that is certain to converge profitably may nevertheless have to be abandoned at a loss, for instance because those who provide arbitrageurs with capital withdraw it prematurely in the face of adverse price movements. The analysis of this risk in Shleifer and Vishny 1997 was prescient: as chapter 8 suggests, a flight of arbitrage capital of this kind was integral to the crisis surrounding Long-Term Capital Management. — Donald MacKenzie, An Engine, Not a Camera, 1217

Categorization

• XREF: Connects to the wider financialization/limits-of-arbitrage literature, especially Shleifer and Vishny 1997, and the LTCM crisis narrative. — connects to: Market arbitrage requires only that investors prefer more wealth to less, not risk preferences — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 180; The M-M debate hinged on whether arbitrage could overcome institutional restrictions — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 193; Arbitrageurs deliberately conceal exploitable market inefficiencies because disclosure destroys them. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 457 (+8 more)

Broader Connections

• Arbitrage erodes the profitability of exploiting the index inclusion anomaly #complicates (0.75) — Donald MacKenzie, An Engine, Not a Camera, 462