Abstract
Will arbitrage capital flow into a market experiencing a shock, mitigating the adverse effect on price efficiency? Not necessarily. In a stochastic dynamic equilibrium model with privately informed capital-constrained arbitrageurs, price efficiency plays a dual role, determining both the profitability of new arbitrage and the release rate of engaged arbitrage capital. An adverse shock reducing price efficiency locks in existing arbitrage positions, thereby decreasing future efficiency. A decrease in future price efficiency in turn lengthens arbitrage duration, deterring arbitrageurs, further reducing current efficiency. This self-reinforcing mechanism creates endogenous regimes: temporary shocks can trigger "hysteresis," a persistent shift in price efficiency.