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The Limits of the Limits of Arbitrage

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  • Alon Brav
  • J.B. Heaton
  • Si Li

Abstract

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. Copyright 2010, Oxford University Press.

Suggested Citation

  • Alon Brav & J.B. Heaton & Si Li, 2010. "The Limits of the Limits of Arbitrage," Review of Finance, European Finance Association, vol. 14(1), pages 157-187.
    • Handle: RePEc:oup:revfin:v:14:y:2010:i:1:p:157-187
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    File URL: http://hdl.handle.net/10.1093/rof/rfp018
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    Cited by:

    1. Chiah, Mardy & Long, Huaigang & Zaremba, Adam & Umar, Zaghum, 2023. "Trade competitiveness and the aggregate returns in global stock markets," Journal of Economic Dynamics and Control, Elsevier, vol. 148(C).
    2. Cakici, Nusret & Fieberg, Christian & Metko, Daniel & Zaremba, Adam, 2023. "Machine learning goes global: Cross-sectional return predictability in international stock markets," Journal of Economic Dynamics and Control, Elsevier, vol. 155(C).
    3. Borja Amor-Tapia & Maria T. Tascon, 2016. "Separating Winners from Losers: Composite Indicators Based on Fundamentals in the European Context," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 66(1), pages 70-94, February.
    4. Neszveda, G., 2019. "Essays on behavioral finance," Other publications TiSEM 05059039-5236-42a3-be1b-3, Tilburg University, School of Economics and Management.
    5. Cosemans, Mathijs & Frehen, Rik, 2021. "Salience theory and stock prices: Empirical evidence," Journal of Financial Economics, Elsevier, vol. 140(2), pages 460-483.
    6. Paul Brockman & Dennis Y. Chung & Kenneth W. Shaw, 2017. "The R&D-abnormal return anomaly: a transaction cost explanation," Review of Quantitative Finance and Accounting, Springer, vol. 48(2), pages 385-406, February.
    7. Jacobs, Heiko, 2015. "What explains the dynamics of 100 anomalies?," Journal of Banking & Finance, Elsevier, vol. 57(C), pages 65-85.
    8. Cao, Jie & Han, Bing, 2016. "Idiosyncratic risk, costly arbitrage, and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 1-15.
    9. Zaremba, Adam & Umutlu, Mehmet & Maydybura, Alina, 2020. "Where have the profits gone? Market efficiency and the disappearing equity anomalies in country and industry returns," Journal of Banking & Finance, Elsevier, vol. 121(C).
    10. Hung, Weifeng & Lin, Ching-Ting & Yang, J. Jimmy, 2022. "Aggregate 52-week high, limited attention, and time-varying momentum profits," Journal of Banking & Finance, Elsevier, vol. 141(C).
    11. DeLisle, R. Jared & Ferguson, Michael F. & Kassa, Haimanot & Zaynutdinova, Gulnara R., 2021. "Hazard stocks and expected returns," Journal of Banking & Finance, Elsevier, vol. 125(C).
    12. Pavel Bandarchuk & Jens Hilscher, 2013. "Sources of Momentum Profits: Evidence on the Irrelevance of Characteristics," Review of Finance, European Finance Association, vol. 17(2), pages 809-845.
    13. Liu, Chang & Sun, Peng & Zhu, Dongming, 2023. "Lottery preference, short-sale constraint, and the salience effect: Evidence from China," Economic Modelling, Elsevier, vol. 125(C).
    14. Aboulamer, Anas & Kryzanowski, Lawrence, 2016. "Are idiosyncratic volatility and MAX priced in the Canadian market?," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 20-36.
    15. A. William Richardson & Kevin Veenstra, 2022. "The Post‐earnings Announcement Drift: A Pre‐earnings Announcement Effect? A Multi‐period Analysis," Abacus, Accounting Foundation, University of Sydney, vol. 58(4), pages 648-678, December.
    16. Bergbrant, Mikael & Kassa, Haimanot, 2021. "Is idiosyncratic volatility related to returns? Evidence from a subset of firms with quality idiosyncratic volatility estimates," Journal of Banking & Finance, Elsevier, vol. 127(C).
    17. DeLisle, R. Jared & McTier, Brian C. & Smedema, Adam R., 2016. "Systematic limited arbitrage and the cross-section of stock returns: Evidence from exchange traded funds," Journal of Banking & Finance, Elsevier, vol. 70(C), pages 118-136.
    18. Peterson, David R. & Smedema, Adam R., 2011. "The return impact of realized and expected idiosyncratic volatility," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2547-2558, October.
    19. Broman, Markus S., 2016. "Liquidity, style investing and excess comovement of exchange-traded fund returns," Journal of Financial Markets, Elsevier, vol. 30(C), pages 27-53.
    20. Jungmu Kim & Yuen Jung Park, 2019. "Is Low-Volatility Investing Sustainable in the SME Stock Market of Korea? A Risk and Return Analysis," Sustainability, MDPI, vol. 11(13), pages 1-17, July.

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