Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers
Journal of Financial Intermediation, Vol. 19, No. 4, 2010
University of Alberta School of Business Research Paper No. 2013-204
Posted: 23 May 2013 Last revised: 30 May 2013
There are 2 versions of this paper
Costly Arbitrage and Idiosyncratic Risk: Evidence from Short Sellers
Date Written: May 22, 2009
Abstract
Previous studies have shown that high short interest stocks have low subsequent returns. We test whether the persistence of this effect is due to costs limiting arbitrage. The arbitrage cost that we focus on is idiosyncratic risk which, regardless of the arbitrageur’s level of diversification, deters arbitrage activity. Consistent with costly arbitrage, we find that among high short interest stocks a one standard deviation increase in idiosyncratic risk predicts a more than 1% decline in monthly returns. Moreover, idiosyncratic risk does not predict returns across low short interest stocks, and short interest does not predict low returns across low idiosyncratic risk stocks. Our results are robust to commonly used proxies for both transaction costs and short sale constraints.
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