Arbitrageurs and overreaction to earnings surprises

This paper explores whether arbitrage trades could cause overreaction to earnings announcements. We contrast two hypotheses in a horse race: (1) whether short covering over positive news stocks generates overshooting in stock returns; (2) whether momentum traders trying to arbitrage the post-earnings announcements drift cause overreaction. We find evidence in line with the two hypotheses, but the overshooting is stronger for stocks with high covering. Also, we find that short sellers spot this overreaction and trade these stocks intensively. However, they trade more stocks with high short covering, suggesting that short sellers close their positions quickly to open new ones.

Automated summary

This study finds that arbitrage trades may lead to overreaction to earnings announcements, especially for stocks with high short covering. Short sellers are able to spot this overreaction and trade, but they tend to choose stocks with high short covering, quickly closing their positions to open new ones.