Under the adaptive market hypothesis, it has been suggested that the stock market oscillates between periods of efficiency and inefficiency. The purpose of the study is to explore the possibility of empirically testing whether arbitrage opportunities can be exploited by an investor through a trading strategy during periods of market inefficiency. We propose that during periods of market inefficiency arbitrage opportunities are identified using a directional trading strategy in a multi-country setting. A directional trading strategy is based on the direction of index returns. This trading strategy is able to capture patterns in the index return data. According to the efficient market hypothesis (EMH) full information for a stock is reflected in the stock price. Market participants will not be able to generate arbitrage opportunities using a trading strategy. The availability of arbitrage opportunities contradicts the EMH as investors can identify patterns in the prices and can initiate trades in order to generate a riskless profit. The EMH has remained a popular topic of finance and the debate on whether an investor can generate arbitrage opportunities in an efficient market continues.
Data/Methods:
This trading strategy is applied when an index displays periods of market inefficiency identified using Auto Boot, Auto Q, Breusch Godfrey and General Spectral tests. The data for the study consisted of 210 monthly closing prices for each of 44 indices belonging to 39 countries. The data were obtained from Bloomberg data systems for the period of February 1999 to July 2016. The study sample consisted of 9284 observations.
Results/Expected Results:
We find positive empirical evidence that an investor can generate and exploit arbitrage opportunities by applying a direction-of-returns-based directional trading strategy on a sample of 44 monthly stock indices belonging to 39 countries during the period February 2001 to July 2016.