International Finance Discussion Papers (IFDP)
January 2015
A Model of Anomaly Discovery
Qi Liu, Lei Lu, Bo Sun, and Hongjun Yanand
Abstract:
We analyze a model of anomaly discovery. Consistent with existing evidence, we show that the discovery of an anomaly reduces its magnitude and increases its correlation with existing anomalies. One new prediction is that the discovery of an anomaly reduces the correlation between deciles 1 and 10 for that anomaly. Using data for 12 well-known anomalies, we find strong evidence consistent with this prediction. Moreover, the correlation between deciles 1 and 10 of an anomaly becomes correlated with the aggregate hedge-fund wealth volatility after the anomaly is discovered. Our model also sheds light on how to distinguish between risk- and mispricing-based anomalies.
Keywords: Anomaly, Arbitrage, Discovery, Arbitrageur-based asset pricing.
DOI: http://dx.doi.org/10.17016/IFDP.2015.1128
PDF: Full Paper