Fast and Slow Arbitrageurs: Implications for Return Predictability

Abstract

We present a model to explain puzzling patterns surrounding cross-sectional night-minus-day return predictabilities. Heterogeneous (“fast” and “slow”) arbitrageurs with offsetting advantages endogenously become the marginal investor at different times of day. Consistent with our model, we find that predictable night-minus-day returns are associated with persistent (rather than mean-reverting) order imbalances and with price deviations at open (rather than at close). Larger expected order imbalances lead to larger night-minus-day returns, except among stocks traded overseas before the U.S. market open. Fast arbitrageurs' capital constraints predict night-minus-day returns but not close-to-close returns, while the opposite is true for slow arbitrageurs' constraints.

Keywords: Fast and slow arbitrageurs, return predictability, night-minus-day returns, endogenous limited participation, tug of war

JEL Classification: G12, G14, G23