Arbitrage Risk Research Articles

Post-Earnings-Announcement Drift: The Role of Revenue Surprises

The study reported here consisted of estimating earnings and sales (or revenue) surprises either with historical time-series data or with analyst forecasts. Post-earnings-announcement drift was found to be stronger when the revenue surprise was in the same direction as the earnings surprise. This result proved to be robust to various controls, including the proportions of stock held by institutional investors, arbitrage risk, and turnover (prior 60-month average trading volume). This finding is consistent with prior evidence that earnings surprises have a more persistent effect on future earnings growth when they consist of higher revenue surprises than when they consist of lower expense surprises.

Discussion of An Analysis of the Theories and Explanations Offered for the Mispricing of Accruals and Accrual Components

In an interesting and provocative paper, Kraft, Leone, and Wasley (henceforth, KLW) conduct an in-depth analysis of Sloan's [1996] earnings fixation hypothesis as a causal explanation for the accrual anomaly. The earnings fixation hypothesis predicts that abnormal returns are high (low) following low (high) accruals. A testable implication is that a strategy that buys the decile of stocks with the lowest accruals, and sells the decile of stocks with the highest accruals, earns excess returns. These apparently predictable excess returns following readily observable components of earnings are puzzling from a market efficiency perspective, and there is a variety of hypotheses to explain them. However, as Sloan [1996, p. 314] first observes, these returns do not necessarily imply investor irrationality or the existence ofunexploited profit opportunities. Trading costs, arbitrage risk, or other risk mismeasurement may explain the returns without contradicting market efficiency (Kothari

The New Shareholder Activism

In this paper, we begin by documenting the successes and failures of institutional shareholder activism in recent years in section I. We find that overall institutional activism has been of marginal importance at targeted firms. We then move on in section II to contrast institutional investor activism with the much more aggressive recent activism of the hedge fund managers. This discussion leads us to define the costs and benefits of hedge fund activism for each of the four major broad types of strategies that these funds have pursued: information asymmetry and convergence trades; capital structure motivated trades; merger and risk arbitrage; and most controversially, governance and strategy. This analysis shows that while there are benefits derived from hedge fund activism there are clear costs as well. Governance and strategy activism emerges as the most important force affecting corporate governance. We assemble some empirical evidence about the extent of this activism, including a list of the most active hedge funds with the number of significant equity positions they took in 2005. Additionally, for the period 1999 to 2005, we document the enormous upswing in hedge fund 13D filings in target companies revealing positions in excess of five percent. By examining a sample of these filings, we find that they overwhelmingly state that the hedge fund's purpose is to engage in activist behavior. While much more analysis remains to be done, the evidence we present in this paper points to the importance of hedge fund activism as a new force that is causing rapid corporate governance changes.

The Limits of Arbitrage: Evidence from Fundamental Value-to-Price Trading Strategies

Shleifer and Vishny (1997) argue that arbitrage can be both costly and risky. As a result, arbitrageurs will not exploit arbitrage opportunities if the costs and risk of arbitrage exceed its benefits, thereby allowing mispricing to survive for long periods of time. Frankel and Lee (1998) document that the fundamental value-to-price (Vf/P) ratio predicts future abnormal returns for up to three years, where Vf is an estimate of fundamental value based on a residual income model that uses analyst earnings forecasts. Ali, Hwang and Trombley (2003a) further show that their results seem consistent with the mispricing explanation rather than with the risk explanation of the Vf/P effect. Thus, the Vf/P effect provides a good means to examine the limits of arbitrage. We find that the Vf/P effect is extremely weak in stocks of old age (measured by the history of listing), low investor sophistication, high divergence of opinion, high idiosyncratic return volatility, and high transaction costs. Further analysis shows that firm age, earnings quality, and divergence of opinion have incremental power beyond other measures of risk in explaining the cross-sectional variation in the Vf/P effect. Our results appear to be consistent with the argument of the limits of arbitrage. More specifically, when arbitrageurs exploit arbitrage opportunities, they seek to avoid mispriced stocks with the greatest arbitrage risk. JEL Classification: G10, G11, G14

A test of risk arbitrage profitability

We explore the performance of risk arbitrage involving three types of merger offers: cash tender, stock swap, and collar offers for the period between 1990 and 2000. Our result reveals that risk arbitrage for a successful stock offer generates higher returns than a successful cash offer. This finding implies that the profitability of risk arbitrage depends on the level of asymmetric information associated with the payment method. We also find that the beta of typical risk arbitrage positions/portfolios is heavily influenced by the payment method and market conditions.

Arbitrage opportunities and their implications to derivative hedging

We explore the role that random arbitrage opportunities play in hedging financial derivatives. We extend the asymptotic pricing theory presented by Fedotov and Panayides [Stochastic arbitrage return and its implication for option pricing, Physica A 345 (2005) 207–217] for the case of hedging a derivative when arbitrage opportunities are present in the market. We restrict ourselves to finding hedging confidence intervals that can be adapted to the amount of arbitrage risk an investor will permit to be exposed to. The resulting hedging bands are independent of the detailed statistical characteristics of the arbitrage opportunities.

What Can Rational Investors Do About Excessive Volatility?

We determine and analyze the trading strategy that would allow an investor to take advantage of the excessive stock price volatility that has been documented in the empirical literature on asset pricing. We construct a general equilibrium model where stock prices are excessively volatile because there are two classes of agents and one class places is overconfident about a public signal. As a result, these agents change their expectations too often, sometimes being excessively optimistic, sometimes being excessively pessimistic. We analyze the trading strategy of the rational investors who are not overconfident about the signal. While rational risk-arbitrageurs benefit from trading on their belief that the market is being foolish, when doing so they must hedge future fluctuations in the market's foolishness. We find that fixed-income instruments can be used for the purpose of hedging. Thus, our analysis illustrates that risk arbitrage cannot be based on just a current price divergence; it must include also a protection against trading risk. We also show that the presence of a few rational traders is not sufficient to eliminate the excessive volatility effect of overconfident investors generated by the presence of overconfident investors. Furthermore, overconfident investors of this kind tend to survive for a long time before being driven out of the market by rational investors.

Heterogeneous Beliefs and Momentum Profits

Recent theoretical models derive return continuation in a setting where investors have heterogeneous beliefs or receive heterogeneous information. This paper tests the link between heterogeneity of beliefs and return continuation in the cross-section of US stock returns. Heterogeneity of beliefs about a firm's fundamentals is measured by the dispersion in analyst forecasts of earnings. The results show that momentum profits are significantly larger for portfolios characterized by higher heterogeneity of beliefs. Predictive cross-sectional regressions show that heterogeneity of beliefs has a positive incremental effect on return continuation after controlling for variables measuring a stock's visibility, the speed of information diffusion, uncertainty about fundamentals, information precision, and volatility. The results in this paper are robust to the potential presence of short-sale constraints and are not explained by arbitrage risk.

How Profitable is Capital Structure Arbitrage?

This paper examines the risk and return of the so-called capital structure arbitrage, which exploits the mispricing between a company's debt and equity. Specifically, a structural model connects a company's equity price with its credit default swap (CDS) spread. Based on the deviation of CDS market spreads from their theoretical counterparts, a convergence-type trading strategy is proposed and analyzed using 135,759 daily CDS spreads on 261 obligors. At the level of individual trades, the risk of the strategy arises when the arbitrageur shorts CDS and the market spread subsequently skyrockets, forcing the arbitrageur into early liquidation and engendering large losses. An equally-weighted portfolio of all trades produces Sharpe ratios similar to those of other fixed-income arbitrage strategies and hedge fund industry benchmarks. However, the monthly excess returns on this portfolio are not significantly correlated with either equity or bond market factors.

Arbitrage Risk and Post‐Earnings‐Announcement Drift

This study examines whether the magnitude of post‐earnings‐announcement drift is related to the risk faced by arbitrageurs, who may view the anomaly as a trading opportunity. Consistent with this hypothesis, the magnitude of the drift is strongly related to the arbitrage risk measure developed by Wurgler and Zhuravskaya (2002). The effect of arbitrage risk is statistically and economically significant in a range of specifications. The results support the view of post‐earnings‐announcement drift as an underreaction to earnings information.

Heterogeneous Investors and their Changing Demand and Supply Schedules for Individual Common Stocks

Using 550 million limit orders submitted in the Korea Stock Exchange, we estimate demand and supply elasticities of heterogeneous investor types and their changes around the Asian financial crisis. We find that domestic individuals have substantially more inelastic demand and supply curves than domestic institutions and foreign investors. The crisis permanently reduced price elasticities of domestic individuals by 50% but had no effect on those of foreign investors. Institutional changes restricting margin purchases, implemented after the crisis, seem particularly important in explaining the dramatic drop. Information heterogeneity, availability of close substitutes and arbitrage risk also explain time-series variations in elasticities.

Why is the Accrual Anomaly not Arbitraged Away?

Sloan (1996) and several follow up papers show that the stock market behaves as though it cannot understand the implications of accruals for future earnings. We propose and find evidence consistent with the hypothesis that risk-averse arbitrageurs are unable to eliminate accrual related mispricing because individual stocks in the extreme accrual deciles do not have close substitutes. Note that the textbook theory of arbitrage is predicated on the ability of the arbitrageur to find perfect substitutes for mispriced stocks. Our results suggest that arbitrage risk impedes arbitrageurs from eliminating accrual mispricing.

Arbitrage Risk and the Book-to-Market Anomaly

Arbitrage Risk and the Book-to-Market Anomaly

Basel 2: the risk to the global consensus

Basel 2 has been the subject of intense debate amongst bankers around the world. It will replace the original Basel Accord of 1988, but unlike the latter it looks as if the new Accord will undermine the global consensus. It is a costly exercise and the heightened risk of regulatory arbitrage may yet distort the competitive landscape. In particular, the completely different ways in which Basel 2 will be implemented in the USA and EU pose a challenge for institutions that operate on a global scale. This article is a brief examination of the key differences and challenges posed by the draft Accord – the prospects for a “final” draft being truly final seem remote and Basel 3 may well have to be on the agenda before the ink is dry on Basel 2.

Arbitrage risk induced by transaction costs

We discuss the time evolution of quotation of stocks and commodities and show that they form an Ising chain. We show that transaction costs induce arbitrage risk that is usually neglected. The full analysis of the portfolio theory is computationally complex but the latest development in quantum computation theory suggests that such a task can be performed on quantum computers.

Post-Earnings-Announcement Drift: The Role of Revenue Surprises and Earnings Persistence

This study explores an additional factor that is associated with differential levels of the post-earnings-announcement drift (henceforth drift) the contemporaneous surprise in revenues. Consistent with prior evidence about greater persistence of revenues and greater noise caused by heterogeneity of expenses, this study shows that the earnings drift is stronger when the revenue surprise is in the same direction as the earnings surprise. Moreover, the study provides direct evidence that the drift is stronger when the earnings persistence is greater. The results are robust to various controls, including the proportions of stock held by institutional investors, trading liquidity, and arbitrage risk.

Expanding the Limits of Merger Arbitrage

In this paper we show that when bidders are in the S&P 500 Index, risk arbitrage portfolio returns are 85 percent larger than when they are not. We also show that acquisitions by S&P 500 buyers are more likely to be completed, and take less time to complete, than are deals by different buyers. These results indicate that risk arbitrage returns can be extended by strategies involving S&P 500 bidders. In addition, we find share price runups followed by price reversals on all buyer types when stock, and not cash, is used as currency for the acquisition. This phenomenon occurs around merger completion, which is a non-information day. Thus, our finding documents that the buyers' short-run demand curve exhibits inelastic behavior, and is evidence in support for Scholes' (1972) price-pressure hypothesis.

Arbitrage risk and the book-to-market anomaly

This paper shows that the book-to-market ( B/M) effect is greater for stocks with higher idiosyncratic return volatility, higher transaction costs, and lower investor sophistication, consistent with the market-mispricing explanation for the anomaly. The B/M effect for high volatility stocks exceeds that for the low volatility stocks in 20 of the 22 sample years. Also, volatility exhibits significant incremental power beyond transaction costs and investor sophistication measures in explaining cross-sectional variation in the B/M effect. These findings are consistent with the Shleifer and Vishny (1997) thesis that risk associated with the volatility of arbitrage returns deters arbitrage activity and is an important reason why the B/M effect exists.

Price Pressure on the NYSE and Nasdaq: Evidence from S&P 500 Index Changes

Using additions of NYSE- and Nasdaq-listed firms to the S&P 500, between 1989 and 2000, we explore the price effects of noninformation related demand shocks. After controlling for various firm characteristics, index fund growth, and arbitrage risk, we find that NYSE stocks suffer less pronounced price effects than do Nasdaq stocks on the day stocks are added to the Index. For NYSE stocks, this effect is reversed immediately, but Nasdaq stocks, show a partial reversal taking place over several days. We interpret this result as evidence of the superiority of the specialist system over the dealer system in mitigating price pressures. An important facet of any stock market is its ability to absorb large demand shocks for stocks while minimizing any resulting change in price. In this article, we compare the price effects for Nasdaq and NYSE stocks added to the S&P 500 Index. Our experiment allows us to study the impact of exchange listing on the effects of large demand shocks that are relatively clean of confounding information. This issue is more than an academic curiosity, since both the NYSE and the Nasdaq claim that their respective systems are better able to absorb such shocks (Wall Street Journal, July 26, 2000). The arguments of both sides have validity. The NYSE argues that the centralized specialist can see the big picture and manage supply more effectively than can a dispersed network of dealers. The NYSE also has the benefit of investor-supplied liquidity in the form of the limit order book (Cochrane, 1993), and the specialist is committed to taking offsetting positions in each stock he is assigned. Nasdaq claims that its dispersed dealer system is better able to minimize the price impact of additions for several reasons (see Groth and Dubofsky, 1987). First, there is greater competition

Arbitrage Risk and Post-Earnings-Announcement Drift

This study examines whether the magnitude of post-earnings-announcement drift is related to the risk faced by arbitrageurs who may view the anomaly as a trading opportunity. Consistent with this hypothesis, the magnitude of the drift is strongly related to the arbitrage risk measure developed by Wurgler and Zhuravskaya (2002). The effect of arbitrage risk is statistically and economically significant under a wide range of specifications. The results suggest that post-earnings-announcement drift represents an underreaction to earnings information and that arbitrage risk impedes arbitrageurs from eliminating it.