Global Versus Local Asset Pricing: Evidence from Arbitrage of the MSCI Index Change

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Abstract
Large-scale simultaneous asset demand shocks like index revisions modify stock betas market-wide and generate testable cross sectional asset pricing implications. This paper develops a model of limited arbitrage which characterizes the cross-sectional return dynamics around a partially anticipated public announcement of an index revision. Arbitrage by risk averse speculators implies that stock returns prior to the announcement are not only positively proportional to the anticipated beta decrease of each stock, but also negatively proportional to the marginal arbitrage risk contribution of each speculative position. The redefinition of the MSCI international equity index in 2001 and 2002 provides a powerful event study to test these predictions and delivers strong evidence in favor of the new model. Importantly, the global nature of the MSCI index revision implies that global and local beta changes differ substantially along with the respective marginal arbitrage risk incurred to exploit them. Testing which beta changes and marginal arbitrage risk terms are price relevant reveals that MSCI stocks are priced globally and not locally.

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