Abstract
I model the behavior of an arbitrageur who is exposed to time-varying liquidity. She is averse to liquidating her position in a bad liquidity state. Therefore, she limits her trading in stocks having high variation in liquidity. In equilibrium, these stocks experience severe mispricing due to reduced arbitrage activity. Consistent with the model, in empirical tests, I find higher mispricing in these stocks. The results are not explained by the level of liquidity or idiosyncratic volatility. Furthermore, the negative relationship between variation in liquidity and returns, documented in prior literature, is absent after accounting for the mispricing due to limited arbitrage.
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