Price Impact Costs and the Limit of Arbitrage
EFA 2002 Berlin Meetings Presented Paper; Yale ICF Working Paper No. 00-66
60 Pages Posted: 10 Jul 2002
Date Written: February 26, 2002
This paper investigates whether one can profit from the size, book-to-market, or momentum anomaly, when price-impact costs are taken into account. A non-linear price-impact function is individually estimated for 5173 stocks to assess the magnitude of trading costs. Compared to constant proportional transaction costs (as typically assumed in the literature), a concave price-impact function tends to assign a higher impact cost to mid-size trades and a lower impact to large-size trades. We implement long-short arbitrage strategies based on each such anomaly, and estimate the maximal fund size possible before excess returns become negative. For all anomalies, the maximal fund sizes are small in order to remain profitable. Markets are therefore bounded-rational: price-impact costs deter agents from exploiting the anomalies.
Keywords: Stock market anomaly, Price-impact function, Arbitrage, Fund size limit
JEL Classification: G1
Suggested Citation: Suggested Citation