Self-fulfilling arbitrages necessitate crash risk

Abstract

We propose a model in which hedge funds can initiate a sequence of arbitrage opportunities and a potential market crash without any exogenous shock. When hedge fund managers share a concern about a rare event, not necessarily affecting the fundamentals, some hedge funds may opt out for fear of redemption risk, leading to coordination failure. Our model demonstrates that the coordination failure generates an arbitrage opportunity but it comes with a chance of a market crash. It explains hedge funds’ low leverage before the recent financial crisis and discusses their conflicting features of causing a financial crisis and enhancing market efficiency.