Textbook arbitrage needs no capital and bears no risk. A convert arb desk that is long cheap bonds and short stock knows that is fiction: margin, haircuts, and investor redemptions can force sales exactly when model cheapness looks best. Shleifer and Vishny (1997) give the agency model behind that fact — specialised arbitrageurs manage other people's money, capital follows past returns (performance-based arbitrage), and in extreme circumstances the specialist liquidates when opportunities are greatest. This note is the theory sibling to the practical funding spiral in Funding, Liquidity and Why Cheapness Can Persist.
Learning objectives. By the end of this note you should be able to:
- contrast textbook arbitrage with capital-using risk arbitrage (Bund futures example);
- state the three-period agency setup and the performance-based capital rule ;
- explain Propositions 1–4: when specialists hold cash, when they are fully invested, and why they liquidate as mispricing worsens;
- map the model's empirical implications onto convert-arb desks (specialisation, volatility, anomalies).
In this lesson
- Textbook vs realistic arbitrage
- The agency model (Section I)
- Extreme circumstances (Section II)
- Empirical implications (Section IV) — convert desk reading
The full lesson, with worked examples and exercise solutions, is for members.
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