Working Paper: CEPR ID: DP6094
Authors: Harald Hau
Abstract: We develop a framework to explore the asset pricing implications of simultaneous supply shocks in multiple assets in a setting with limits-to-arbitrage. The portfolio approach in Greenwood (2005) is generalized to allow for asymmetric information and therefore net positions of arbitrageurs against uninformed liquidity providers. We predict that announcement returns are not only positively proportional to the asset premium change of each stock (like in Greenwood), but also negatively proportional to the risk contribution of the arbitrage position captured by the product of the squared return covariance matrix and the vector of supply changes. The redefinition of the MSCI international equity index in 2001 and 2002 provides a powerful event study to test these predictions. We find strong evidence in favour of our generalized model of limited arbitrage. Moreover, asset pricing effects of weight changes across stocks are quantitatively similar for domestic and foreign stocks. MSCI stocks are therefore priced globally and not locally.
Keywords: Index Revisions; International Equity; Arbitrage; Portfolio Theory
JEL Codes: G11; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| supply shocks (E39) | announcement returns (E60) |
| asset premium change (G32) | announcement returns (E60) |
| risk contribution of the arbitrage position (G13) | announcement returns (E60) |
| announcement returns (E60) | asset premium change (G32) |
| announcement returns (E60) | risk contribution of the arbitrage position (G13) |