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Short- and long-term demand curves for stocks: Evidence on the dynamics of arbitrage Robin Greenwood * [email protected] First draft: October 2000 This draft: March 17, 2003 Abstract I derive a simple model of demand curves for portfolios of assets at different time horizons and apply it to a unique index rebalancing event in Japan. In the short-run, demand curves are downward sloping, with the slope determined by the contribution of the portfolio of assets to the total risk of a diversified arbitrageur. Demand curves flatten over time, reducing the long-term effects of changes in the supply of assets on prices. The model is applied to a redefinition of the Nikkei 225 stock index, in which 30 stocks were replaced and 195 stocks were significantly downweighted. The event caused an estimated ¥2 trillion in rebalancing by institutional investors. During a week with no major economic news, the additions gained 19%, the deletions fell by 32%, and the remainders fell by 13%. More than 70% of these returns were reversed within 20 weeks of the event. Consistent with the model, stocks with lower (higher) event returns experienced higher (lower) post-event returns. * Harvard Business School. A previous version of this paper was circulated under the title “Large Events and Limited Arbitrage: Evidence from a Japanese stock Index Redefinition”. I thank Malcolm Baker, Ken Froot, Seki Obata, Jorge Rodriguez, Mark Seasholes, Josh White, Andrei Shleifer, Nathan Sosner, Jeremy Stein, Jeffrey Wurgler and seminar participants at MIT and Harvard for helpful comments.
Short- and long-term demand curves for stocks: Evidence on the dynamics of arbitrage Abstract I derive a simple model of demand curves for portfolios of assets at different time horizons and apply it to a unique index rebalancing event in Japan. In the short-run, demand curves are downward sloping, with the slope determined by the contribution of the portfolio of assets to the total risk of a diversified arbitrageur. Demand curves flatten over time, reducing the long-term effects of changes in the supply of assets on prices. The model is applied to a redefinition of the Nikkei 225 stock index, in which 30 stocks were replaced and 195 stocks were significantly downweighted. The event caused an estimated ¥2 trillion in rebalancing by institutional investors. During a week with no major economic news, the additions gained 19%, the deletions fell by 32%, and the remainders fell by 13%. More than 70% of these returns were reversed within 20 weeks of the event. Consistent with the model, stocks with lower (higher) event returns experienced higher (lower) post-event returns.
1. Introduction In traditional finance theory, asset prices respond only to changes in expected cash flows and discount factors. Uninformed changes in investor demand have no effect on prices, even in the short-run. According to the theory, if securities have perfect substitutes, then investors will always be willing to buy when the price of an asset falls slightly under the fundamental value, or sell when the price rises slightly above.

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