A Cross-Sectional Analysis of the Excess Comovement of Stock Returns
45 Pages Posted: 24 Mar 2005
Date Written: March 11, 2005
Abstract
In the presence of limits to arbitrage, cross-sectional variation in periodic investor demand should be related to the degree of comovement of returns. I exploit the unusual weighting system of the Nikkei 225 index in Japan to identify cross-sectional variation in periodic demand for index stocks. Relative to their weights in a value weighted index, some stocks in the Nikkei are overweighted by a factor of ten or more. Using overweighting as an instrument for the proportionality between demand shocks for index stocks, I find a strong positive relation between overweighting and the comovement of a stock with other stocks in the index, and a negative relationship between index overweighting and comovement with stocks outside of the index. Put simply, overweighted stocks have high betas. The results suggest that excess comovement of stock returns is a consequence of an institutionalized commonality in trading behavior, rather than inefficiencies related to the speed at which index stocks incorporate economy-wide information.
Keywords: Limits to arbitrage, comovement, institutions, behavioral finance
JEL Classification: G12, G13, G15
Suggested Citation: Suggested Citation