Skip Navigation



Review of Finance Advance Access published online on October 4, 2009
Review of Finance, doi:10.1093/rof/rfp018
This Article
Right arrow Full Text
Right arrow Full Text (PDF)
Right arrow Alert me when this article is cited
Right arrow Alert me if a correction is posted
Services
Right arrow Email this article to a friend
Right arrow Similar articles in this journal
Right arrow Alert me to new issues of the journal
Right arrow Add to My Personal Archive
Right arrow Download to citation manager
Right arrowRequest Permissions
Google Scholar
Right arrow Articles by Brav, A.
Right arrow Articles by Li, S.
Social Bookmarking
Add to CiteULike   Add to Connotea   Add to Del.icio.us  
What's this?

The Authors 2009. Published by Oxford University Press on behalf of the European Finance Association. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

The Limits of the Limits of Arbitrage

Alon Brav1, J.B. Heaton2 and Si Li3

1 Professor of Finance, Duke University Fuqua School of Business
2 Partner, Bartlit Beck Herman Palenchar & Scott LLP
3 Assistant Professor of Finance, Wilfrid Laurier University School of Business and Economics

Please address correspondence to Brav at Fuqua School of Business, Duke University, Box 90120, Durham, North Carolina 27708–0120, email: brav{at}duke.edu

We test the limits of arbitrage argument for the survival of irrationality-induced financial anomalies by sorting securities on their individual residual variability as a proxy for idiosyncratic risk – a commonly asserted limit to arbitrage – and comparing the strength of anomalous returns in low versus high residual variability portfolios. We find no support for the limits of arbitrage argument to explain undervaluation anomalies (small value stocks, value stocks generally, recent winners, and positive earnings surprises) but strong support for the limits of arbitrage argument to explain overvaluation anomalies (small growth stocks, growth stocks generally, recent losers, and negative earnings surprises). Other tests also fail to support the limits of arbitrage argument for the survival of overvaluation anomalies and suggest that at least some of the factor premiums for size, book-to-market, and momentum are unrelated to irrationality protected by limits to arbitrage.

JEL Classification: G11, G12, G14

We thank Ray Ball, Nick Barberis, Zahi Ben-David, Peter Bossaerts (the editor), Michael Brandt, Markus Brunnermeier, George Constantinides, Campbell Harvey, Dong Hong, Ron Kaniel, Reuven Lehavy, Jon Lewellen, Mark Loewenstein (a discussant), Toby Moskowitz, Doron Nissim, Per Olsson, Matthew Rothman, Darren Roulstone, Ronnie Sadka, Richard Thaler, Mohan Venkatachalam, Mitch Warachka, two anonymous referees, and seminar participants at the Seventh Maryland Finance Symposium, the Securities and Exchange Commission Office of Economic Analysis, Duke University, Hebrew University, Interdisciplinary Center, Herzlyia, Israel, Northwestern University and Vanderbilt University for helpful comments.

Heaton acknowledges that the opinions expressed here are his own, and do not reflect the position of Bartlit Beck Herman Palenchar & Scott LLP or its attorneys. Li acknowledges financial support from the Social Sciences and Humanities Research Council of Canada.


Add to CiteULike CiteULike   Add to Connotea Connotea   Add to Del.icio.us Del.icio.us    What's this?




Disclaimer: Please note that abstracts for content published before 1996 were created through digital scanning and may therefore not exactly replicate the text of the original print issues. All efforts have been made to ensure accuracy, but the Publisher will not be held responsible for any remaining inaccuracies. If you require any further clarification, please contact our Customer Services Department.