ETF Arbitrage and Return Predictability
58 Pages Posted: 21 Nov 2016 Last revised: 22 Jan 2018
Date Written: January 22, 2018
Demand shocks generate mispricing between identical securities leading to arbitrage activity that restores relative price efficiency. However, relative price efficiency does not imply absolute price efficiency as either demand shocks or subsequent trades by arbitrageurs may push assets prices away from latent fundamental values. In theory, if arbitrage trades are observable, such distortions are short-lived. Exchange traded funds (ETFs) provide a novel setting in which arbitrage trades are publicly observable shortly after they occur. We find that arbitrage activity negatively predicts subsequent returns, indicating that market participants fail to incorporate this observable information into prices.
Keywords: Arbitrage, Weak-Form Market Efficiency, Return Predictability, Exchange Traded Funds (ETFs), Demand Shocks
JEL Classification: G12, G14
Suggested Citation: Suggested Citation