The limits of the limits of arbitrage

Published

Journal Article

We test the limits of arbitrage argument for the survival of irrationality-induced financial anomalies by sorting securities on their individual residual variability as a proxy for idiosyncratic risk - a commonly asserted limit to arbitrage - and comparing the strength of anomalous returns in low versus high residual variability portfolios. We find no support for the limits of arbitrage argument to explain undervaluation anomalies (small value stocks, value stocks generally, recent winners, and positive earnings surprises) but strong support for the limits of arbitrage argument to explain overvaluation anomalies (small growth stocks, growth stocks generally, recent losers, and negative earnings surprises). Other tests also fail to support the limits of arbitrage argument for the survival of overvaluation anomalies and suggest that at least some of the factor premiums for size, book-to-market, and momentum are unrelated to irrationality protected by limits to arbitrage.

Full Text

Duke Authors

Cited Authors

  • Brav, A; Heaton, JB; Li, S

Published Date

  • January 1, 2010

Published In

Volume / Issue

  • 14 / 1

Start / End Page

  • 157 - 187

Electronic International Standard Serial Number (EISSN)

  • 1573-692X

International Standard Serial Number (ISSN)

  • 1572-3097

Digital Object Identifier (DOI)

  • 10.1093/rof/rfp018

Citation Source

  • Scopus