Costly Arbitrage and the Myth of Idiosyncratic Risk

35 Pages Posted: 24 Jun 2005

See all articles by Jeffrey Pontiff

Jeffrey Pontiff

Boston College - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: December 17, 2005

Abstract

Transaction and holding costs make arbitrage costly. If some traders are rational, mispricing will only exist to the extent that arbitrage costs prevent rational traders from fully eliminating inefficiencies. Although the relation between mispricing and transaction costs is well-known, the relation between mispricing and holding costs is misunderstood. One holding cost, idiosyncratic risk, is particularly misunderstood. Various myths are debunked, including the common myth that arbitrageurs care about idiosyncratic risk because they are undiversified [Shleifer and Vishny (1997)]. The literature demonstrates that idiosyncratic risk is the single largest cost faced by arbitrageurs.

Keywords: Arbitrage, market efficiency, idiosyncratic risk

JEL Classification: G00, G14, M40

Suggested Citation

Pontiff, Jeffrey, Costly Arbitrage and the Myth of Idiosyncratic Risk (December 17, 2005). Available at SSRN: https://ssrn.com/abstract=749125 or http://dx.doi.org/10.2139/ssrn.749125

Jeffrey Pontiff (Contact Author)

Boston College - Department of Finance ( email )

Carroll School of Management
140 Commonwealth Avenue
Chestnut Hill, MA 02467-3808
United States

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