The Limits of Arbitrage: Evidence from Fundamental Value-to-Price Trading Strategies

Shleifer and Vishny (1997) argue that arbitrage can be both costly and risky. As a result, arbitrageurs will not exploit arbitrage opportunities if the costs and risk of arbitrage exceed its benefits, thereby allowing mispricing to survive for long periods of time. Frankel and Lee (1998) document that the fundamental value-to-price (Vf/P) ratio predicts future abnormal returns for up to three years, where Vf is an estimate of fundamental value based on a residual income model that uses analyst earnings forecasts. Ali, Hwang and Trombley (2003a) further show that their results seem consistent with the mispricing explanation rather than with the risk explanation of the Vf/P effect. Thus, the Vf/P effect provides a good means to examine the limits of arbitrage. We find that the Vf/P effect is extremely weak in stocks of old age (measured by the history of listing), low investor sophistication, high divergence of opinion, high idiosyncratic return volatility, and high transaction costs. Further analysis shows that firm age, earnings quality, and divergence of opinion have incremental power beyond other measures of risk in explaining the cross-sectional variation in the Vf/P effect. Our results appear to be consistent with the argument of the limits of arbitrage. More specifically, when arbitrageurs exploit arbitrage opportunities, they seek to avoid mispriced stocks with the greatest arbitrage risk. JEL Classification: G10, G11, G14