BarclayHedge Industry Trends

Anomaly Discovery and Arbitrage Trading

Written by Admin | Apr 20, 2023 8:34:01 PM

Written By: Xi Dong, Qi Liu, Lei Lu, Bo Sun, Hongjun Yan

 

Abstract

The authors analyze a model in which an anomaly is unknown to arbitrageurs until its discovery, and test the model implications on both asset prices and arbitrageurs’ trading activities. Using data on 99 anomalies documented in the existing literature, they find that the discovery of an anomaly reduces the correlation between the returns of its decile-1 and decile-10 portfolios. This discovery effect is stronger if the aggregate wealth of hedge funds is more volatile. Finally, hedge funds increase (reverse) their positions in exploiting anomalies when their aggregate wealth increases (decreases), further suggesting that these discovery effects operate through arbitrage trading.

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