Limited Arbitrage and Noise Momentum

69 Pages Posted: 11 May 2011 Last revised: 21 Jul 2012

See all articles by Charlie X. Cai

Charlie X. Cai

University of Liverpool Management School

Robert W. Faff

University of Queensland

Yongcheol Shin


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

Cai, Charlie Xiaowu and Faff, Robert W. and Shin, Yongcheol, Limited Arbitrage and Noise Momentum (July 19, 2012). Available at SSRN: or

Charlie Xiaowu Cai (Contact Author)

University of Liverpool Management School ( email )

University of Liverpool
Liverpool, L69 7ZA
United Kingdom

Robert W. Faff

University of Queensland ( email )

St Lucia
Brisbane, Queensland 4072

Yongcheol Shin


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