The Limits of Arbitrage and Stock Mispricing: Evidence from Decomposing the Market to Book Ratio

Abstract

We investigate how security specific mispricing may persist under limits to arbitrage; specifically, when arbitragers are limited by the availability of substitutes and financial constraints. We use a part of the market to book decomposition as a proxy for mispricing. The availability of substitutes measure is developed by utilizing the predicted values from a propensity score matching technique based on the Fama and French three-factor model. Arbitrageurs’ financial constraint is captured by the skewness of returns. We find that, on average, stocks with closer substitutes have lower firm specific mispricing, while financial constraints have a positive impact on firm specific mispricing.

Keywords: Limits of arbitrage, mispricing, availability of substitute, financial constraints

JEL Classification: G00, G10, G11, G12