DP6094 A Generalized Portfolio Approach to Limited Risk Arbitrage: Evidence from the MSCI Global Index Change

Author(s): Harald Hau

Publication Date: February 2007

Keyword(s): index revisions , international equity arbitrage , portfolio theory

JEL(s): G11 , G14 , G15

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP6094.asp.asp

We develop a framework to explore the asset pricing implications of simultaneous supply shocks in multiple assets in a setting with limits-to-arbitrage. The portfolio approach in Greenwood (2005) is generalized to allow for asymmetric information and therefore net positions of arbitrageurs against uninformed liquidity providers. We predict that announcement returns are not only positively proportional to the asset premium change of each stock (like in Greenwood), but also negatively proportional to the risk contribution of the arbitrage position captured by the product of the squared return covariance matrix and the vector of supply changes. The redefinition of the MSCI international equity index in 2001 and 2002 provides a powerful event study to test these predictions. We find strong evidence in favour of our generalized model of limited arbitrage. Moreover, asset pricing effects of weight changes across stocks are quantitatively similar for domestic and foreign stocks. MSCI stocks are therefore priced globally and not locally.