Arbitrage costs and nonlinear adjustment in the G7 stock markets

Abstract

This article aims to study stock price adjustments towards fundamentals due to the existence of arbitrage costs defined as the sum of transaction costs and a risky arbitrage premium associated with the uncertainty characterizing the fundamentals. Accordingly, it is shown that a two regime Smooth Transition Error Correction Model (STECM) is appropriate to reproduce the dynamics of stock price deviations from fundamentals in the G7 countries during the period 1969 to 2005. This model takes into account the interdependences or contagion effects between stock markets. Deviations appear to follow a quasi random walk in the central regime when prices are near fundamentals (i.e. when arbitrage costs are greater than expected arbitrage profits, the mean reversion mechanism is inactive), while they approach a white noise in the outer regimes (i.e. when arbitrage costs are lower than expected arbitrage profits, the mean reversion is active). Interestingly, as expected when arbitrage costs are heterogeneous, the estimated STECM shows that stock price adjustments are smooth and that the convergence speed depends 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 both the date and the country under consideration.