Net arbitrage trading in the korean stock market

Abstract

This study examines the net arbitrage trading (NAT) in the Korean stock market, measured by the difference between the Abnormal Holdings of Foreign investors (AHF) and Abnormal Short Interest (ASI). NAT captures the time-series composite trading activities of the long side and the short side, and significantly predicts positive future returns in the cross-section. We confirm that foreign investors are really the skilled investors, whereas institutional investors’ trading activity have no return predictive power, in the Korean stock market. By examining ten well-known stock anomalies, we find that the excess returns of stock anomalies are primarily driven by stocks traded by arbitrageurs. We also find that arbitrageurs significantly withdraw their arbitrage capital allocation and cause severe exacerbation of mispricing in the Korean stock market during the crisis period. We further investigate net arbitrage trading by looking at the relationship between sentiment, and find that our NAT measure truly captures the mispricing and arbitrage, and consistent to the rationale of limit to arbitrage. Finally, we revisit our main analysis using daily data and reconfirm our main findings.