Abstract
We propose a parsimonious, comprehensive proxy for innovations in limited arbitrage: the divergence between the return on an ETF and the return on the underlying net asset value. Consistent with a common component, we confirm limited arbitrage risk-factors, LAF, constructed from return divergence spanning four asset classes are correlated. Consistent with well-known factors that limit arbitrage, increased volatility and market illiquidity, we find that equity LAFs are negatively priced in the cross-section of stock returns. However, our pricing tests confirm that LAFs also provide pricing information beyond well-known limits to arbitrage. Overall, our findings suggest that limited arbitrage risk is priced and LAF is a relevant risk-factor.
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