Does uncertainty affect the limits of arbitrage? Evidence from the U.S. stock markets

Abstract

This study analyzes how uncertainty affects the correction process of mispricing. We extract stock market data from the United States spanning from January 1976 to December 2016, and discover that uncertainty exerts a notable impact on traders’ decision-making processes. Various robustness tests have been conducted to validate the credibility of our findings. Notably, the extension of the sample duration until December 2022, encompassing the disruptive COVID-19 pandemic, serves to fortify the cohesion and reliability of our primary analysis, with the findings exhibiting consistency. Additionally, we examine how investor sentiment affects future returns under different uncertainty and overpricing ranks. An inverse relation between investor sentiment and uncertainty is also detected. We contribute to the existing literature by revealing potential features that affect the limits of arbitrage. Our results provide insights in designing arbitrage mechanisms and assist arbitrageurs in strategizing their operations with stocks under different magnitudes of uncertainty.