Limited Arbitrage and Noise Momentum
69 Pages Posted: 11 May 2011 Last revised: 21 Jul 2012
Date Written: July 19, 2012
Extending Shleifer and Vishny (1997), we show that arbitrageurs will strategically limit their initial investment in an arbitrage opportunity in anticipation of further mispricing caused by the deepening of noise traders’ misperceptions. Such ‘noise momentum’ is an important determinant of the overall arbitrage process. We develop a state-dependent, two-period error-correction model to test our predictions. Applying it to the S&P500 index futures market we find strong evidence of noise momentum. However, our analysis shows no strong link between initial mispricing correction and noise momentum – consistent with the countervailing forces coming from the strategic response versus capital constraints of arbitrageurs.
Keywords: Limited Arbitrage, Noise Momentum, Futures and Spot Prices, Markov Switching Model
JEL Classification: C12, C22, G13, G14
Suggested Citation: Suggested Citation