a1 Department of Finance, School of Business and Public Administration, Old Dominion University, Norfolk, VA 23529, and Judge Business School, University of Cambridge, Cambridge CB2 1AG, UK. email@example.com
a2 Department of Accountancy, City University of Hong Kong, Tat Chee Ave., Kowloon, Hong Kong. firstname.lastname@example.org
a3 Department of Finance, College of Business Administration, University of South Florida, 4202 E. Fowler Ave., BSN 3403, Tampa, FL 33620. email@example.com
In this paper we examine the relation between equity mispricing and arbitrage risk and find that stocks with high arbitrage risk have higher estimated mispricing than stocks with low arbitrage risk. These results are not limited to high book-to-market or small capitalization stocks, and they are not sensitive to transaction and short-selling costs. In addition, they remain robust to alternative multifactor return generating specification models and mispricing measures. Overall, our empirical results are consistent with the conjecture that mispricing is a manifestation of the inability of arbitrageurs to hedge idiosyncratic risk, a major deterrent to arbitrage activity.
We acknowledge the contribution of IBES International Inc. for providing earnings per share forecast data, available through Institutional Brokers’ Estimate System. The paper has benefited from the comments of Michael Brennan, Stephen Brown (the editor), David Hirshleifer, and Jeffrey Pontiff (associate editor and referee). We also thank PhD seminar participants at the 2004 European Financial Management Association (EFMA) meetings for helpful suggestions. All errors are our own.