The Limits of the Limits of Arbitrage

Posted: 25 Jan 2010 Last revised: 18 Feb 2019

See all articles by Alon Brav

Alon Brav

Duke University - Fuqua School of Business

J.B. Heaton

J.B. Heaton, P.C.

Si Li

Wilfrid Laurier University - School of Business & Economics

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2010

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.

Keywords: G11, G12, G14

Suggested Citation

Brav, Alon and Heaton, J.B. and Li, Si, The Limits of the Limits of Arbitrage (January 1, 2010). Review of Finance, Vol. 14, Issue 1, pp. 157-187, 2010. Available at SSRN: https://ssrn.com/abstract=1541045 or http://dx.doi.org/rfp018

Alon Brav (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-2908 (Phone)
919-684-2818 (Fax)

J.B. Heaton

J.B. Heaton, P.C. ( email )

20 West Kinzie
17th Floor
Chicago, IL 60654
United States
(312) 487-2600 (Phone)

HOME PAGE: http://jbheaton.com

Si Li

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
Canada

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