There is such a thing as a free lunch, but it will cost you: a study on costly arbitrage and the index effect

Sammanfattning: This thesis examines how stock returns around inclusions into and exclusions from the Swedish OMX Stockholm Benchmark and OMX Stockholm 30 indices are affected by arbitrage risk and transaction costs. We observe that during the 30 trading days preceding the announcement of a stock's inclusion in either index, stocks with high arbitrage risk and high transaction costs experience high positive abnormal returns, and vice versa. We conclude that arbitrage risk, i.e. the absence of close substitutes, and transaction costs both prevent arbitrage from flattening the demand curves for stocks. This suggests that mispricings are more likely to occur in stocks with high arbitrage risk and high transaction costs. However, we do not find any statistically significant corresponding relationships for stocks being excluded from either index. Finally, we study post-announcement abnormal returns and conclude that its relationship with arbitrage risk and transaction costs is vague in theory and ambiguous in practice.