Mispricing and Costly Arbitrage
20 Pages Posted: 31 Aug 2008
Date Written: August 27, 2008
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: Suggested Citation