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Leverage Constraints, Arbitrage Capital, and Investor Under-reaction

We analyze a hand-collected sample of earnings announcements over the period, 1934 – 1975, when the Fed changed margin requirements 22 times. We find that higher margin requirements are associated with greater under-reaction to earnings surprises. These results are stronger when investors face greater arbitrage risk or limited attention. They are robust when we control for macroeconomic conditions, financial market conditions, sentiment, or risk, and when we analyze several indirect measures of leverage constraints using more recent data. Our findings suggest that leverage constraints limit capital available to arbitrageurs, and thereby prevent the timely incorporation of earnings information into prices.