Comovement in Arbitrage Limits

Abstract

Estimates of mispricing, such as deviations from no-arbitrage relations, strongly comove across five financial markets. One common component---the arbitrage gap---explains the majority of variability in mispricing estimates for futures, Treasury securities, foreign exchange, and options. Prominent equity anomalies also comove significantly with the arbitrage gap. Variables affecting arbitrage capital availability, such as the TED spread and hedge fund flows and returns, explain two-thirds of the arbitrage gap’s variation. During periods of tighter capital constraints, the comovement in mispricings becomes stronger. The findings support theoretical predictions that common sources of funding shocks can cause comovement in mispricings across markets.

Keywords: Limits of arbitrage, anomalies, market efficiency, hedge funds

JEL Classification: G12, G14, G23