Idiosyncratic Risk, Costly Arbitrage, and the Cross-Section of Stock Returns

Abstract:     
We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of limits to arbitrage. If idiosyncratic risk prevents arbitrageurs from offsetting the choices of irrational inventors and arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, then there should be a positive relation between expected return and expected idiosyncratic volatility for relatively undervalued stocks, but a negative relation for relatively overvalued stocks. We combine several well-known anomalies to measure a stock's relative mispricing. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for relatively undervalued (overvalued) stocks. Overall, our paper supports limits to arbitrage and idiosyncratic risk as an important arbitrage cost.

Number of Pages in PDF File: 36

Keywords: limits to arbitrage, idiosyncratic risk, mispricing

JEL Classification: G12

working papers series