Momentum Trading and Limits to Arbitrage

Abstract:     
An extensive body of research supports the momentum strategy’s persistence but disagrees on the underlying source of its profitability. This paper studies the endogenous relationship between momentum trading and mispricing. The basic idea is that momentum trades can impede arbitrage when they are in the opposite direction of arbitrage trades and reinforce arbitrage when trades are in the same direction. We show that an arbitrage-reinforcing momentum strategy has significantly higher average returns that are largely related to risk and do not reverse in subsequent periods, while an arbitrage-impeding momentum strategy exhibits significant long-term reversal consistent with more mispricing. An important implication of our findings is that, like noise traders, trading strategies that do not condition on relative value can impede arbitrage.

Number of Pages in PDF File: 50

Keywords: momentum, market efficiency, limits-to-arbitrage

JEL Classification: G12, G14

working papers series