Dissecting Arbitrage Costs

65 Pages Posted: 24 Sep 2016 Last revised: 20 Mar 2017

See all articles by FY Eric C Lam

FY Eric C Lam

Independent Consultant

Chishen Wei

Singapore Management University - Lee Kong Chian School of Business

K.C. John Wei

Hong Kong Polytechnic University

Date Written: March 1, 2017

Abstract

This paper systematically examines the impact of nine popular arbitrage costs measures on cross-sectional mispricing based on ten well-known and robust anomalies. We show that binding arbitrage barriers slowly change over time. In early years with few publications documenting return anomalies, arbitrage costs have tiny impact even though mispricing is present. As anomalies become more widely known, arbitrage costs impact mispricing substantially. Arbitrage risk, ambiguity of fundamental value, round-trip broker’s commission plus bid-ask spreads, and stock loan supply are binding on arbitrageurs. Only arbitrage risk is binding if larger cap stocks are emphasized. In recent years when market quality improves and some arbitrageurs become more creative, only round-trip broker’s commission plus bid-ask spreads and stock loan supply remain binding on arbitrageurs. If larger cap stocks are emphasized, arbitrage costs do not matter at all because there is no longer mispricing. An empirical arbitrage costs model based on these simple dynamics subsumes annually-varying principal components of arbitrage costs in affecting mispricing. Incorporating our findings into future capital market efficiency research would mitigate type I and II errors in empirical tests applying the limits-to-arbitrage argument.

Keywords: Arbitrage costs; arbitrage risk; information uncertainty; transaction costs; mispricing

JEL Classification: G12; G14

Suggested Citation

Lam, Full Yet Eric Campbell and Wei, Chishen and Wei, Kuo-Chiang (John), Dissecting Arbitrage Costs (March 1, 2017). Asian Finance Association (AsianFA) 2017 Conference, Available at SSRN: https://ssrn.com/abstract=2842514 or http://dx.doi.org/10.2139/ssrn.2842514

Chishen Wei

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore
Singapore

Kuo-Chiang (John) Wei

Hong Kong Polytechnic University ( email )

11 Yuk Choi Rd
Hung Hom
Hong Kong

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