Arbitrage strongCapitalstrong and Real Investment.pdfVIP

Arbitrage Capital and Real Investment∗ Sergey Chernenko Adi Sunderam Harvard University Harvard University schernenko@hbs.edu sunderam@fas.harvard.edu November 22, 2009 Abstract We study the relationship between the supply of arbitrage capital and real investment. The investment of firms that depend on convertible debt for financing responds positively to flows into convertible arbitrage hedge funds. An extra $1 of fund flows increases capital expenditures of convertible dependent firms by $0.49. At the same time, convertible arbitrage strategy returns are uncorrelated with the stock returns of convertible dependent firms. Moreover, fund flows respond positively to lagged strategy returns but not to lagged returns of dependent firms, suggesting that the supply of capital is not driven by changes in firm investment opportunities. We also examine an isolated market dislocation that occurred in 2005 when funds suffered large withdrawals. Though the macroeconomic outlook was positive and stable, dependent firms sharply cut their investment in response to the withdrawal of capital, with the overall reduction in capital expenditures amounting to 55% of outflows. Our results suggest that firm investment responds to shocks to the supply of arbitrage capital. JEL Classifications: G23, G31 Key Words : convertible bonds, firm investment, hedge funds ∗We would like to thank John Campbell, Robin Greenwood, Sam Hanson, David Scharfstein, Erik Stafford, and Jeremy Stein and seminar participants at Harvard for helpful comments and suggestions. 1