Arbitrage Risk and the Book-to-Market Anomaly

This paper shows that the book-to-market (B/M) effect is greater for stocks with higher idiosyncratic return volatility, higher transaction costs and lower investor sophistication, consistent with the market mispricing explanation for the anomaly. The B/M effect for high volatility stocks exceeds that for the low volatility stocks in 20 of the 22 sample years. Also, volatility exhibits significant incremental power beyond the transaction costs and investor sophistication measures in explaining cross-sectional variation in the B/M effect. These findings are consistent with the Shleifer and Vishny (1997) thesis that risk associated with the volatility of arbitrage returns deters arbitrage activity and is an important reason why the B/M effect exists.

[1]  J. Stein,et al.  Breadth of Ownership and Stock Returns , 2001 .

[2]  Ronald J. Lanstein,et al.  Persuasive evidence of market inefficiency , 1985 .

[3]  S. Viswanathan,et al.  A theory of the interday variations in volume , 1990 .

[4]  E. Fama,et al.  Efficient Capital Markets : II , 2007 .

[5]  Suresh Radhakrishnan,et al.  Investor Sophistication and Patterns in Stock Returns after Earnings Announcements , 2000 .

[6]  Anat R. Admati,et al.  A Theory of Intraday Patterns: Volume and Price Variability , 1988 .

[7]  Brad M. Barber,et al.  Can Investors Profit from the Prophets? Consensus Analyst Recommendations and Stock Returns , 1998 .

[8]  Charles M. C. Lee,et al.  Price Momentum and Trading Volume , 1998 .

[9]  Richard A. Ippolito.  Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry , 1992, The Journal of Law and Economics.

[10]  Josef Lakonishok,et al.  Fundamentals and Stock Returns in Japan , 1991 .

[11]  Hans R. Stoll,et al.  Transaction costs and the small firm effect , 1983 .

[12]  E. Fama,et al.  The Cross‐Section of Expected Stock Returns , 1992 .

[13]  Patricia M. Dechow,et al.  Returns to contrarian investment strategies: Tests of naive expectations hypotheses , 1997 .

[14]  E. Fama,et al.  Risk, Return, and Equilibrium: Empirical Tests , 1973, Journal of Political Economy.

[15]  Patricia M. Dechow,et al.  Short-sellers, fundamental analysis, and stock returns , 2001 .

[16]  Ravi Bhushan,et al.  An informational efficiency perspective on the post-earnings announcement drift , 1994 .

[17]  E. Fama,et al.  Industry costs of equity , 1997 .

[18]  Vincent A. Warther.  Aggregate mutual fund flows and security returns , 1995 .

[19]  Peter J. Knez,et al.  Estimating the Profits from Trading Strategies , 1996 .

[20]  Jeffrey Wurgler,et al.  Does Arbitrage Flatten Demand Curves for Stocks? , 2000 .

[21]  Ilia D. Dichev.  Is the Risk of Bankruptcy a Systematic Risk , 1998 .

[22]  E. Fama,et al.  Risk, Return, and Equilibrium , 1971, Journal of Political Economy.

[23]  Josef Lakonishok,et al.  Contrarian Investment, Extrapolation, and Risk , 1993 .

[24]  E. Fama,et al.  Common risk factors in the returns on stocks and bonds , 1993 .

[25]  S. P. Kothari,et al.  Another Look at the Cross-section of Expected Stock Returns , 1995 .

[26]  A. Kyle.  Continuous Auctions and Insider Trading , 1985 .

[27]  W. Newey,et al.  Hypothesis Testing with Efficient Method of Moments Estimation , 1987 .

[28]  Terence Lim,et al.  Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies , 1998 .

[29]  A. Lo,et al.  Stock Market Prices Do Not Follow Random Walks: Evidence from a Simple Specification Test , 1987 .

[30]  Marc R. Reinganum.  The anomalous stock market behavior of small firms in January: Empirical tests for tax-loss selling effects , 1983 .

[31]  Andrei Shleifer,et al.  Good News for Value Stocks: Further Evidence on Market Efficiency , 1995 .

[32]  L. Brooks,et al.  The January Anomaly: Effects of Low Share Price , 1992 .

[33]  Richard G. Sloan,et al.  Earnings Surprises, Growth Expectations, and Stock Returns or Don't Let an Earnings Torpedo Sink Your Portfolio , 1999 .

[34]  David Mayers,et al.  The value line enigma (1965-1978) : A case study of performance evaluation issues , 1982 .

[35]  Josef Lakonishok,et al.  Evaluating the performance of value versus glamour stocks The impact of selection bias , 1995 .

[36]  Charles Trzcinka,et al.  A New Estimate of Transaction Costs , 1999 .

[37]  M. Brennan,et al.  Investment Analysis and the Adjustment of Stock Prices to Common Information , 1993 .

[38]  A. Shleifer,et al.  The Limits of Arbitrage , 1995 .

[39]  Jeffrey Pontiff.  Costly Arbitrage: Evidence from Closed-End Funds , 1996 .

[40]  E. Fama.  EFFICIENT CAPITAL MARKETS: A REVIEW OF THEORY AND EMPIRICAL WORK* , 1970 .