Momentum Trading and Limits to Arbitrage

Abstract

An extensive body of research supports the momentum strategy's persistence but disagrees on the underlying source of its profitability. A key obstacle to distinguishing between behavioral and rational explanations of momentum is that mispricing is unobservable. This dissertation studies the endogenous relationship between momentum trading and mispricing. The basic idea is that momentum trades can impede arbitrage when they are in the opposite direction of arbitrage trades and reinforce arbitrage when they are in the same direction. A simple model suggests that when momentum trades reinforce the arbitrage process, momentum strategy returns contain relatively less mispricing than when momentum trades impede the arbitrage process. Empirical results show that an arbitrage-reinforcing strategy has significantly higher average returns that are largely related to risk and do not reverse in subsequent periods, while an arbitrage-impeding strategy exhibits significant long-term reversal consistent with more mispricing. Additional tests show that winners have higher future growth rates than losers consistent with cross-sectional differences in expected returns. Overall, the evidence suggests that momentum profitability is largely related to risk which is partially masked by mispricing. An important implication of this model is that, like noise traders, trading strategies that do not condition on relative value can impede arbitrage.