The Effect of Arbitrage Constraints on Stock Returns

The traditional view on stock return proposes that stock price changes due to systematic changes in the fundamental value of the firm. But the view of behavioral finance as an alternative to the view of the fundamentalist conjectures that the limits to arbitrage and investors psychology actually affects stock price. Limits to arbitrage prevent sophisticated investors from quickly exploiting mispricings. Jacob (2015) reports that time varying limits to arbitrage and investors sentiment play an important role in explaining various market anomalies. This paper attempts to investigate into the effect of arbitrage limits on the price of stocks traded in the Korean stock market. We constructed the arbitrage limits index using principal component of five arbitrage limit variables. Our findings are as follows; 1) while market risk, SMB, and HLM shows positive impacts on the return of individual stock, arbitrage constraint index has negative impact. 2) after controlling market risk, a negative ACI effect appears in the highest BM portfolio. 3) all the coefficients of the arbitrage constraint index for 25 size-BM quintile portfolios are significantly negative after controlling size or (and) value risk. These results imply that limits to arbitrage systematically affect the stock price of Korean firms.