Arbitrage Asymmetry, Mispricing Gap, and Momentum Prediction

Abstract

I introduce a measure called mispricing gap (Mgap), which is the mispricing score gap between overpriced winners and underpriced losers. I find that Mgap predicts stock momentum because it can intuitively measure the level of persistence in trading behaviors of both sentiment investors and arbitrageurs. This predictability is statistically and economically significant both in-sample and out-of-sample. The in-sample predictability remains even when accounting for various state-of-the-art common risk factors and existing predictors. A one standard deviation increase in Mgap boosts next month's momentum returns by 1.10%, which is over 90\% of the historical 1.16% return.

Keywords: stock momentum, mispricing score, arbitrage asymmetry

JEL Classification: G12, G14, G17