Theory suggests that traders are reluctant to trade on negative private information about a

corporate decision if their trading can cause a reversal of the decision. We provide evidence for such endogenous limits to arbitrage in the context of mergers. Starting from the observation that an acquirer termination fee increases the cost of canceling a transaction, potentially breaking the feedback loop between prices and decisions, we find the amount of firm-specific information in post-announcement acquirer stock prices to be significantly lower if no termination fee is used than when a termination fee is used.

We contrast the patterns of abnormal trading activity by two categories of informed traders: outside arbitrageurs (hedge funds and short sellers), and inside ones (firm and its insiders). We find that while net trading by arbitrageurs (NAT) and firms (NFT) are uncorrelated, both independently predict future stock returns. Notably, the return predictability of NFT is more long-lasting compared to that of NAT. Examining a comprehensive set of anomalies, we observe significant divergences in the trading responses of NAT and NFT. We find that NFT capitalizes on anomaly signals that are persistent in nature, whereas NAT targets those that are more transient. This pattern is also pronounced on two anomalies that are central to asset pricing: Firms trade against momentum, while outside arbitrageurs trade against profitability. This difference shows that firm insiders have a better understanding of fundamental performances, unlike outside arbitrageurs who focus more on short-term market trends and news.

We propose a model in which arbitrageurs act strategically in markets with entry costs. In a repeated game, arbitrageurs choose to specialize in some markets, which leads to the highest combined profits. We present evidence consistent with our theory from the options market, in which suboptimally unexercised options create arbitrage opportunities for intermediaries. Using transaction-level data, we identify the corresponding arbitrage trades. Consistent with the model, only 57% of these opportunities attract entry by arbitrageurs. Of those that do, 50% attract only one arbitrageur. Finally, our paper details how market participants circumvent a regulation devised to curtail this arbitrage strategy.