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Statistical Arbitrage and Market Efficiency: Enhanced Theory, Robust Tests and Further Applications

54 Pages Posted: 3 Feb 2005  

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Melvyn Teo

Singapore Management University - Lee Kong Chian School of Business

Yiu Kuen Tse

Singapore Management University - School of Social Sciences

Mitch Warachka

University of San Diego

Date Written: February 2005

Abstract

Statistical arbitrage enables tests of market efficiency which circumvent the joint-hypotheses dilemma. This paper makes several contributions to the statistical arbitrage framework. First, we enlarge the set of statistical arbitrage opportunities in Hogan, Jarrow, Teo, and Warachka (2004) to avoid penalizing incremental trading profits with positive deviations from their expected value. Second, we provide a statistical methodology to remedy the lack of consistency and statistical power in their Bonferroni approach. In addition, this procedure allows for autocorrelation and non-normality in trading profits. Third, we apply our tests to a wide range of trading strategies based on stock momentum, stock value, stock liquidity, and industry momentum. Over 50% of these strategies are found to violate market efficiency. We also identify dominant trading strategies which converge to arbitrage most rapidly.

Keywords: Market Efficiency, Financial Anomalies

JEL Classification: G12, G14

Suggested Citation

Jarrow, Robert A. and Teo, Melvyn and Tse, Yiu Kuen and Warachka, Mitch, Statistical Arbitrage and Market Efficiency: Enhanced Theory, Robust Tests and Further Applications (February 2005). Available at SSRN: https://ssrn.com/abstract=659941 or http://dx.doi.org/10.2139/ssrn.659941

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

Melvyn Teo

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore, 178899
Singapore
+65 6828 0735 (Phone)
+65 6822 0777 (Fax)

Yiu Kuen Tse

Singapore Management University - School of Social Sciences ( email )

469 Bukit Timah Road
Federal Building #02-05
Singapore, 259756
Singapore
+65 822-0257 (Phone)
+65 822-8081 (Fax)

HOME PAGE: http://staff.mysmu.edu/yktse/yktsehp.htm

Mitch Warachka (Contact Author)

University of San Diego ( email )

5998 Alcala Park
University of San Diego
San Diego, CA 92110-2492
United States

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