Mispricing and Costly Arbitrage

20 Pages Posted: 31 Aug 2008  

Ronnie Sadka

Boston College - Carroll School of Management

Anna Scherbina

University of California, Davis - Graduate School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: August 27, 2008

Abstract

The equilibrium magnitude of mispricing can be no greater than the cost of arbitraging it away. Yet, mispricing typically arises when the uncertainty about a firm is high, which is precisely when the stock's liquidity is low. This is the case for stocks with high analyst disagreement about future earnings. These stocks tend to be overpriced, with prices converging down as the uncertainty about earnings is resolved, but the stocks' low liquidity suggests that transaction costs significantly reduce the potential arbitrage profits. Positive shocks to market-wide liquidity reduce arbitrage costs and accelerate the convergence of prices to fundamentals.

Keywords: limits to arbitrage, liquidity, analyst disagreement

JEL Classification: G00, G12, G14

Suggested Citation

Sadka, Ronnie and Scherbina, Anna, Mispricing and Costly Arbitrage (August 27, 2008). Available at SSRN: https://ssrn.com/abstract=1260922 or http://dx.doi.org/10.2139/ssrn.1260922

Ronnie Sadka

Boston College - Carroll School of Management ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

Anna D. Scherbina (Contact Author)

University of California, Davis - Graduate School of Management ( email )

One Shields Avenue
Davis, CA 95616
United States
(530) 754-8076 (Phone)
(530) 752-2924 (Fax)

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