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Does Arbitrage Flatten Demand Curves for Stocks?

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Author Info
Jeffrey A. Wurgler () (Department of Finance)
Ekaterina V. Zhuravskaya () (General)

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Abstract

In textbook theory, demand curves for stocks are kept flat by riskless arbitrage between perfect substitutes. In reality, however, individual stocks do not have perfect substitutes. The risk inherent in arbitrage between imperfect substitutes may deter risk-averse arbitrageurs from flattening demand curves. Consistent with this suggestion and a simple model of demand curves for stocks, we find that stocks without close substitutes experience differentially higher price jumps upon inclusion into the S&P 500 Index. We conjecture that arbitrage forces are weakest, and other pricing anomalies are severest, among stocks without close substitutes (which include small stocks).

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Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm152.

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Date of creation: 03 Aug 2000
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Handle: RePEc:ysm:somwrk:ysm152

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G1 - Financial Economics - - General Financial Markets

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