Variation in Liquidity and Costly Arbitrage

47 Pages Posted: 2 Aug 2019 Last revised: 3 Mar 2020

Date Written: July 27, 2019

Abstract

I model the behavior of an arbitrageur who is exposed to time-varying liquidity. She is averse to liquidating her position in a bad liquidity state. Therefore, she limits her trading in stocks having high variation in liquidity. In equilibrium, these stocks experience severe mispricing due to reduced arbitrage activity. Consistent with the model, in empirical tests, I find higher mispricing in these stocks. The results are not explained by the level of liquidity or idiosyncratic volatility. Furthermore, the negative relationship between variation in liquidity and returns, documented in prior literature, is absent after accounting for the mispricing due to limited arbitrage.

Keywords: Variation in Liquidity, Limits to Arbitrage, Mispricing, Anomalies, Stochastic Liquidity, Costly Arbitrage, Arbitrage Asymmetry

JEL Classification: G12, G14

Suggested Citation

Kottimukkalur, Badrinath, Variation in Liquidity and Costly Arbitrage (July 27, 2019). Available at SSRN: https://ssrn.com/abstract=3427668 or http://dx.doi.org/10.2139/ssrn.3427668

Badrinath Kottimukkalur (Contact Author)

George Washington University ( email )

2121 I Street NW
Washington, DC 20052
United States

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