Excessive Arbitrage Trading by Overconfidence

Abstract

We investigate the effects of arbitrageurs’ behavioral biases on cross-sectional equity returns. We find evidence that profits of equity market neutral hedge portfolios are positively affected by overconfidence, the effects of which are not subsequently reversed. Further we discover that signals which have signs inconsistent with arbitrageurs’ confidence are treated as of low quality and thus ambiguous. When equity market neutral hedge portfolios are sorted according to arbitrageurs’ overconfidence levels on these hedge portfolios, anomalous return difference between high and low overconfidence-sorted hedge portfolios is on average 9.6% a year in the 2000s, and has increased over the past four decades. Arbitrage trading in the 2000s is excessive in the sense that it has not eroded away the profit opportunities of the hedge portfolios, but instead, create economically and statically significant anomalous temporal profits.

Keywords: Overconfidence, Ambiguity aversion, Excessive arbitrage trading, Market efficiency

JEL Classification: G02, G12