The profitability premium : the effect of arbitrage activity on abnormal trading profits

Abstract

Inspired by the Novy-Marx (2013) paper, the purpose of this thesis is to investigate the profitability premium and the effect of arbitrage activity on its abnormal trading profits over the period from June 1964 to December 2010. The primary contribution is to create a measure of arbitrage activity for the profitability strategy, which we dub coprofitability or CoPROF, mainly based on previous methodology of Lou and Polk (2013) and Huang, Lou and Polk (2016). This new measure is used to determine periods of relatively low and high arbitrage activity and evaluate whether trading in the strategy gets crowded. We show that during periods of low arbitrage activity, the majority of abnormal returns are statistically insignificant. In contrast, times of relatively high arbitrage activity are associated with positive and statistically significant abnormal returns as shown by Fama French 3 Factor model. Moreover, we do not find no indication of long run reversal and crash risk when the arbitrage activity is relatively high as opposed to the momentum and beta strategies.