Arbitrage Risk and Investor Sentiment as Causes of Persistent Mispricing: The European Evidence
32 Pages Posted: 10 Oct 2018 Last revised: 3 Nov 2018
Date Written: August 1, 2018
We investigate the relationship between risk-adjusted returns, arbitrage risk and arbitrage asymmetry, and investor sentiment in the European stock market. Under the assumption that idiosyncratic volatility (IVOL) causes arbitrage risk, we analyze the effects of IVOL on the-abnormal returns of the Euro Stoxx 50 large cap constituents. After classifying the stocks in two mispricing categories, we uncover evidence of arbitrage risk especially in the overpriced group: the highest IVOL overpriced portfolio is the most overpriced, which implies persistent subsequent risk-adjusted returns that slowly revert to zero. When the estimation is performed afresh separating the high- from the low-sentiment periods and controlling for macroeconomic conditions, we find evidence of a negative relation between investor sentiment and IVOL effects, which is yet more pronounced for the highest arbitrage-risk stocks, which is consistent with pure, psychological biases strongly affecting the impact of arbitrage risk on the speed of correction of mispricing.
Keywords: Arbitrage risk, arbitrage asymmetries, idiosyncratic volatility, cross section of stock returns, large caps
JEL Classification: G11, G17, G12, C53
Suggested Citation: Suggested Citation