Arbitrage crashes: Slow-moving capital or market segmentation?∗

The predominant explanation for arbitrage crashes is a lack of investor capital to exploit mispricing. This paper shows that slow moving capital is only partially responsible for the 2005 and 2008 arbitrage crashes in the convertible bond market. Even when convertible bonds where underpriced, investors were still buying strictly dominated straight bonds from the same issuers. This finding suggests that market segmentation exaggerated the convertible arbitrage crashes. Furthermore, it is possible to exploit the market segmentation with a long/short trading strategy providing positive abnormal returns. The strategy is profitable even after accounting for transaction cost.