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Arbitrage Trading: The Long and the Short of It

Author

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  • Yong Chen
  • Zhi Da
  • Dayong Huang

Abstract

We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross-section. Across ten well-known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO, which facilitated short selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits to arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007–09 financial crisis. We confirm our findings using daily data.Received September 1, 2016; editorial decision May 28, 2018 by Editor Andrew Karolyi. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Suggested Citation

  • Yong Chen & Zhi Da & Dayong Huang, 2019. "Arbitrage Trading: The Long and the Short of It," The Review of Financial Studies, Society for Financial Studies, vol. 32(4), pages 1608-1646.
    • Handle: RePEc:oup:rfinst:v:32:y:2019:i:4:p:1608-1646.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhy097
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    Cited by:

    1. Lou, Dong & Polk, Christopher, 2022. "Comomentum: inferring arbitrage activity from return correlations," LSE Research Online Documents on Economics 109318, London School of Economics and Political Science, LSE Library.
    2. Chen, Yong & Kelly, Bryan & Wu, Wei, 2020. "Sophisticated investors and market efficiency: Evidence from a natural experiment," Journal of Financial Economics, Elsevier, vol. 138(2), pages 316-341.
    3. Chen, Yong & Da, Zhi & Huang, Dayong, 2022. "Short selling efficiency," Journal of Financial Economics, Elsevier, vol. 145(2), pages 387-408.
    4. Hanauer, Matthias X. & Lesnevski, Pavel & Smajlbegovic, Esad, 2023. "Surprise in short interest," Journal of Financial Markets, Elsevier, vol. 65(C).
    5. Jing Zhang & Wei Zhang & Youwei Li & Xu Feng, 2022. "The role of hedge funds in the asset pricing: evidence from China," The European Journal of Finance, Taylor & Francis Journals, vol. 28(2), pages 219-243, January.
    6. Vikas Agarwal & Stefan Ruenzi & Florian Weigert, 2018. "Unobserved Performance of Hedge Funds," Working Papers on Finance 1825, University of St. Gallen, School of Finance.
    7. Neuhierl, Andreas & Tang, Xiaoxiao & Varneskov, Rasmus Tangsgaard & Zhou, Guofu, 2022. "Option characteristics as cross-sectional predictors," LawFin Working Paper Series 37, Goethe University, Center for Advanced Studies on the Foundations of Law and Finance (LawFin).
    8. Czech, Robert & Huang, Shiyang & Lou, Dong & Wang, Tianyu, 2021. "Informed trading in government bond markets," Journal of Financial Economics, Elsevier, vol. 142(3), pages 1253-1274.
    9. Ma, Tianyi & Li, Baibing & Tee, Kai-Hong, 2022. "Mispricing chasing and hedge fund returns," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 34-49.
    10. Shi, Yongdong & Wang, Haomiao & Xia, Yu & Zhen, Hongxian, 2023. "Mispricing and anomalies in China," Pacific-Basin Finance Journal, Elsevier, vol. 79(C).
    11. Poutré, Cédric & Dionne, Georges & Yergeau, Gabriel, 2023. "International high-frequency arbitrage for cross-listed stocks," International Review of Financial Analysis, Elsevier, vol. 89(C).
    12. Huang, Dayong & Li, Jay Y. & Wu, Kai, 2021. "The effect of oil supply shocks on industry returns," Journal of Commodity Markets, Elsevier, vol. 24(C).
    13. Han, Yufeng & Huang, Dashan & Huang, Dayong & Zhou, Guofu, 2022. "Expected return, volume, and mispricing," Journal of Financial Economics, Elsevier, vol. 143(3), pages 1295-1315.
    14. Shiyang Huang & Maureen O’Hara & Zhuo Zhong, 2021. "Innovation and Informed Trading: Evidence from Industry ETFs [Short interest, institutional ownership, and stock returns]," Review of Financial Studies, Society for Financial Studies, vol. 34(3), pages 1280-1316.
    15. Guo, Li & Li, Frank Weikai & John Wei, K.C., 2020. "Security analysts and capital market anomalies," Journal of Financial Economics, Elsevier, vol. 137(1), pages 204-230.
    16. Chiu, Junmao & Lien, Donald & Tsai, Wei-Che, 2023. "Global financial crisis, funding constraints, and liquidity of VIX futures," Pacific-Basin Finance Journal, Elsevier, vol. 80(C).
    17. Sinclair, Andrew J., 2023. "Do prime brokers intermediate capital?," Journal of Financial Intermediation, Elsevier, vol. 53(C).
    18. Yong Chen & Bing Han & Jing Pan, 2021. "Sentiment Trading and Hedge Fund Returns," Journal of Finance, American Finance Association, vol. 76(4), pages 2001-2033, August.
    19. Swem, Nathan, 2022. "Information in financial markets: Who gets it first?," Journal of Banking & Finance, Elsevier, vol. 140(C).
    20. Srivastava, Pranjal & Jacob, Joshy, 2022. "Arbitrage constraints and behaviour of volatility components: Evidence from a natural experiment," IIMA Working Papers WP 2022-10-01, Indian Institute of Management Ahmedabad, Research and Publication Department.
    21. Xi Dong & Yan Li & David E. Rapach & Guofu Zhou, 2022. "Anomalies and the Expected Market Return," Journal of Finance, American Finance Association, vol. 77(1), pages 639-681, February.
    22. Nezafat, Mahdi & Shen, Tao & Wang, Qinghai & Wu, Julie, 2022. "Longs, shorts, and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 138(C).
    23. Chen, Haosi (Chelsea) & Puckett, Andy, 2023. "Do Hedge Funds Value Sell-Side Analysts Differently?," Journal of Banking & Finance, Elsevier, vol. 154(C).

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