Variation in Liquidity and Costly Arbitrage
59 Pages Posted: 2 Aug 2019 Last revised: 17 May 2023
Date Written: July 27, 2019
Abstract
Mispricing is severe among stocks with high variation in liquidity. Among underpriced (overpriced) stocks, stocks with high variation in liquidity are more underpriced (overpriced). The mispricing is more pronounced during high investor sentiment periods. The results are not explained by the level of liquidity or idiosyncratic volatility. In addition, the number of ES-SPY arbitrage opportunities increase during months when SPY trading volume is more volatile. The evidence is consistent with variation in liquidity hindering arbitrage. Furthermore, the negative cross-sectional relationship between variation in liquidity and returns, documented in prior literature, disappears 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: Suggested Citation