47 Pages Posted: 9 Apr 2005
Date Written: March 2005
In the presence of limits to arbitrage, cross-sectional variation in periodic investor demand should be related to the degree of comovement of returns. I exploit the unusual weighting system of the Nikkei 225 index in Japan to identify cross-sectional variation in periodic demand for index stocks. Relative to their weights in a value weighted index, some stocks in the Nikkei are overweighted by a factor of ten or more. Using overweighting as an instrument for the proportionality between demand shocks for index stocks, I find a strong positive relation between overweighting and the comovement of a stock with other stocks in the index, and a negative relationship between index overweighting and comovement with stocks outside of the index. Put simply, overweighted stocks have high betas. The results suggest that excess comovement of stock returns is a consequence of an institutionalized commonality in trading behavior, rather than inefficiencies related to the speed at which index stocks incorporate economy-wide information.
Suggested Citation: Suggested Citation
Greenwood, Robin M., A Cross Sectional Analysis of the Excess Comovement of Stock Returns (March 2005). HBS Finance Research Paper No. 05-069. Available at SSRN: https://ssrn.com/abstract=698162 or http://dx.doi.org/10.2139/ssrn.698162
By Meb Faber