Arbitrage Costs and Nonlinear Adjustment in the G7 Stock Markets

Fredj Jawadi (1, 2, 3) , Georges Prat (3)

1 UEVE - Université d'Évry-Val-d'Essonne
2 Amiens School of Management
3 EconomiX - EconomiX

This paper aims to study stock price adjustments toward fundamentals due to the existence of arbitrage costs defined as the sum of transaction costs and a risky arbitrage premium associated to the uncertainty characterizing the fundamentals. Accordingly, it is shown that a two-regime STECM (Smooth Transition Error Correction Model) is appropriate to reproduce the dynamics of stock price deviations from fundamentals in the G7 countries over the period 1969-2005, this model taking into account the interdependences or contagions effects between stock markets. Deviations appear to follow a quasi random walk in the central regime when prices are near fundamentals, while they approach a white noise in the outer regimes. Interestingly, as expected when arbitrage costs are heterogeneous, the estimated STECM highlights that stock price adjustments are smooth and that the convergence speed depend on the size of the deviation. Finally, using two appropriate indicators proposed by Peel and Taylor (2000), both the magnitudes of under- and overvaluation of stock price and the adjustment speed are calculated per date in the G7 countries. These indicators show that the dynamics of stock price adjustment are strongly dependent on the date and on the country under consideration.

Mots clés: Social Sciences & Humanities

Domaines: Économie et finance quantitative [q-fin]

Fredj Jawadi, Georges Prat. Arbitrage Costs and Nonlinear Adjustment in the G7 Stock Markets. Applied Economics, 2011, pp.1. ⟨10.1080/00036846.2010.543085⟩. ⟨hal-00677631⟩