High Arbitrage Costs Research Articles

Social forecasting: Online social opinion and the cross-section of stock returns

We construct a monthly measure for online social opinions on stocks in the Chinese market by extracting textual data from the internet. By implementing a “social forecasting” strategy, we find a significantly positive alpha of 0.544% per month based on the model of Fama-French's (2015) five-factor plus Carhart's (1997) momentum, and 0.636% per month based on Liu et al.'s (2018) Chinese four-factor model. This anomaly is driven by the mispricing of underexplored information since online social opinions are a strong predictor of firms' earning surprise and are strengthened when there are information frictions, such as low investor attention, high arbitrage costs, high proportions of sentiment-driven trades, and low percentages of institutional investors. Our results are robust to a series of tests and remain unchanged after taking the “factor zoo” into consideration.

The return predictability of carbon emissions: Evidence from Hong Kong and Singapore

We examine the relationship between carbon emissions and future stock returns in Hong Kong and Singapore stock markets. Hong Kong-listed stocks with higher carbon emissions experience lower future stock returns. The pattern is driven by non-local stocks and is absent among local stocks. Carbon emissions do not predict future returns in Singapore, where most of listed stocks are local. Investors of non-local firms in Hong Kong underreact to the effect of carbon emissions on firm fundamentals and environmental incidents. Moreover, the return predictability is stronger among stocks with higher information asymmetry, fewer sophisticated investors, and higher arbitrage costs.

Mispricing and anomalies in China

This study examines arbitrage asymmetry effect on six well-known anomalies in China’s stock market. Using a comprehensive mispricing index constructed based on four popular mispricing measures, we show that anomalies are much more pronounced among overpriced stocks, but weaker or even reversed among underpriced stocks. Results also hold after controlling for several existing mispricing proxies and are stronger among stocks with high arbitrage costs. Our finding suggests that arbitrage costs that mostly result from short-sale constraints hinder correction of overpricing and increase the inefficiency of the stock market.

ESG investment in China: Doing well by doing good

This paper provides comprehensive evidence that ESG investors in China can get rewarded by doing good. We construct composite firm-level ESG scores in China covering all the A-share stocks with China-specific ESG-related issues and NLP technologies. We provide strong evidence that stocks with high ESG scores outperform those with low ESG scores in the Chinese A-share stock market, and the premium cannot be reduced by common pricing factors. We find that ESG scores are positively related to firm future fundamentals and the return predictability is more pronounced in stocks with low investor attention and high arbitrage costs. We suggest that current ESG premium is dominated by investors' underreaction to ESG-implied cash flow information rather than risk compensation or investors' preference. Our findings are consistent with the ESG pricing theories, and they can help promote the ESG investment in China.

Labor Market Networks and Asset Returns

This paper proposes a measure of labor market connectivity based on the similarity in the composition of occupational knowledge characteristics across industries and provides evidence of return predictability in the cross-section of industries that are connected through the labor market. In long-short portfolios, an industry's return is strongly predicted by the past return of its labor-market-connected neighboring industries with an annualized return of up to 9%, which is not explained by established asset pricing models. The return predictability remains significant after controlling for the supply chain momentum as well as the industry lead-lag effect, and is concentrated in stocks with higher arbitrage costs and higher ownership of uninformed investors. We find similar predictive relations for the labor productivity, wages, employment, and profitability of labor connected industries. Our findings are consistent with positive spillover of productivity shocks among industries that are connected through the labor market. Informational frictions, costly arbitrage, and investors' limited attention magnify the delayed response of stock prices to the spillover of labor productivity shocks, which results in the observed return predictability.

Oil price shocks, investor sentiment, and asset pricing anomalies in the oil and gas industry

This paper documents that stocks are not efficiently priced in the oil and gas industry. We find significant cross-sectional effects on stock returns from various firm characteristics in the oil and gas industry. Specifically, 13 out of 15 prominent capital market anomalies are robust in the oil and gas industry. Investor sentiment has significantly positive impact on 4 anomalies: composite equity issues, investment to assets, net stock issues, and value effect. Among the three oil shocks, we find that aggregate demand shocks have significantly impact on 6 anomalies: composite equity issues, financial distress, net stock issues, O-SCORE, return on assets, and idiosyncratic volatility. Our results are consistent with the view that high arbitrage costs and risks have significant deterring effects on arbitrage in the oil and gas industry. Our findings also have practical investment and policy implications for investors, firm managers, and policy makers alike.

Fundamental strength strategy: The role of investor sentiment versus limits to arbitrage

This paper evaluates the return predictability of fundamental strength in a two-dimensional framework that considers both investor sentiment and limits to arbitrage simultaneously. Sentiment and limits to arbitrage have independent and overlapping explanatory power on the return predictability of fundamental strength. The return predictability of fundamental strength is more pronounced among stocks with high arbitrage costs following high sentiment. Among stocks with low arbitrage costs, the fundamental strength strategy is profitable only following high sentiment. However, among stocks with high arbitrage costs, the same strategy can earn economically and statistically significant profits even following low sentiment. Consistent with Miller (1977), we emphasize the interaction of sentiment and limits to arbitrage on stock valuation.

Can Retail Investors Learn from Insiders?

This paper examines the trading patterns of retail investors following insider trading and the corresponding price impact. Retail investors follow the opportunistic purchases by insiders, but not their routine purchases. The abnormal retail downloads of the Form 4 filings from the EDGAR database also increase for opportunistic insider purchases. Neither investor attention nor common information such as earnings announcements or analysts forecast revisions explains the results. Moreover, for stocks with opportunistic insider purchases, those that retail investors bought yield higher cumulative abnormal returns than those that retail investors sold. The effect is mostly driven by the information component of the retail trades, rather than liquidity provision or temporary price pressure, and stronger for stocks with greater informational uncertainty and higher arbitrage costs. Variance ratio tests also suggest price efficiency improvements for stocks bought by retail investors following opportunistic insider purchases. The evidence is mostly consistent with retail investors learning from opportunistic insider purchases, and their trading helping expedite price discovery.

Offshore Sales Networks and Stock Return Predictability

Based on 10-K textual analysis, we assemble firm-level offshore sales networks (OSN) and find strong return predictability among industry participants that have overlapping offshore sales activities. This intra-industry return predictability based on offshore sales networks is distinct from that along several previously documented economic linkages (e.g., industry momentum, technological links, and standalone vs conglomerate firms. Moreover, we find that the effect is stronger for firms that receive low investor attention, issue hard-to-read 10-Ks, and pose high arbitrage costs. Our results highlight important asset pricing implications of the commonality of corporate offshore activities, and are broadly consistent with sluggish price adjustment caused by investors’ inattention to offshore networks.

Negative Investment Returns in a Developing Market Context

Financial theory posits a positive relationship between the value of investment that firms undertake and subsequent shareholder returns. Surprisingly, recent studies on United States data have found a negative relationship between investment and subsequent shareholder return. This anomaly contravenes the basic theory of investment, as well as traditional capital asset-pricing models, and several conflicting risk-related and behavioural explanations have been suggested by other researchers. South Africa’s developing market is characterised by relatively high arbitrage costs, and high risk conditions, and offers a suitable context to re-examine this anomaly. This study confirms a negative relationship between the value of investment that firms undertake and subsequent shareholder returns in a developing market context. Over the period from December 2004 to December 2016, shares on the Johannesburg Stock Exchange with lower investment rates consistently outperform shares with higher investment rates. The explanation for this anomaly requires further study.

Do Arbitragers Exploit the January Effect

The January effect has been well documented since the 1970s. This study examines whether the January effect still exists and if it does, whether arbitrageurs exploit it. We find that the January effect is still persistently significant. Furthermore, we find that arbitrageurs appear to exploit the January effect, especially in good market years when the number of losing firms is limited and are therefore more easily identifiable. We also find that the January effect tends to be higher for losing stocks with high arbitrage costs relative to those with low arbitrage costs.

The Information Content of Insider Sudden Silence

This paper explores the information content of insider sudden silence. We hypothesize that insiders strategically choose to be silent when they possess private information not yet reflected in stock prices. Consistent with our hypothesis, insider silence following a routine selling (buying) schedule predicts positive (negative) future abnormal returns as well as earnings surprise. The return predictability of insider silence is stronger among firms with worse information environment and facing higher arbitrage costs, suggesting that investors underweight the information conveyed in insider silence. We also find that insider silence forecasts future firm fundamentals (e.g., ROA, cash flows, and analyst forecast revisions) and that sophisticated investors trade in the direction predicted by the information of insider silence. A long-short portfolio that exploits insiders' strategic silence behavior generates abnormal returns up to 10.4% annually.

Investor Sentiment, Limited Arbitrage and the Cash Holding Effects

We examine the market mispricing and limits-to-arbitrage hypotheses on the positive relation between cash holdings and expected stock returns. Using investor sentiment as a proxy for market mispricing, we find that returns of cash holding stocks are heavily influenced by investor sentiment. Using transaction costs, institutional ownership and idiosyncratic volatility as proxies for limits-to-arbitrage, we show that the cash holding effects are strong among stocks with large transaction and short selling costs, and high idiosyncratic volatility. This indicates that high arbitrage costs and risks prevent arbitrageurs to eliminate the mispricing on the cash holding effects.

Weather-Induced Mood, Institutional Investors, and Stock Returns

This study shows that weather-based indicators of mood impact perceptions of mispricing and trading decisions of institutional investors. Using survey and disaggregated trade data, we show that relatively cloudier days increase perceived overpricing in individual stocks and the Dow Jones Industrial Index and increase selling propensities of institutions. We introduce stock-level measures of investor mood; investor optimism positively impacts stock returns among stocks with higher arbitrage costs, and stocks experiencing similar investor mood exhibit return comovement. These findings complement existing studies on how weather impacts stock index returns and identify another channel through which it can manifest.

The Dispersion Effect in International Stock Returns

We find that stocks exhibiting high dispersion in analysts’ earnings forecasts not only underperform in the U.S. but also in some European countries. Investigating the abnormal returns generated by the dispersion strategy around the world for the 1990-2008 sample period, we observe that the returns of the strategy are uneven, with large abnormal returns realized during the mid-to-late 1990s and the 2000-2003 period. In particular, we document that the dispersion effect is most profitable in a very narrow time frame around the burst of the technology bubble. As a consequence, the dispersion hedge strategy would have been rather difficult to implement, especially given that the highest mispricing obtains for stocks characterized by high arbitrage costs.

Investing in the Asset Growth Anomaly Across the Globe

We document the existence of an anomalous asset growth effect globally and find that it comprises some combination of a market mispricing and some pervasive global systematic risk. To support our findings, we explore a battery of tests to include how country-level governance and market characteristics explain the cross-country differences in the effect. We also find evidence that any profits to a trading strategy based on the asset growth effect globally are somewhat diminished by high arbitrage costs.

Cross section of option returns and idiosyncratic stock volatility

This paper presents a robust new finding that delta-hedged equity option return decreases monotonically with an increase in the idiosyncratic volatility of the underlying stock. This result cannot be explained by standard risk factors. It is distinct from existing anomalies in the stock market or volatility-related option mispricing. It is consistent with market imperfections and constrained financial intermediaries. Dealers charge a higher premium for options on high idiosyncratic volatility stocks due to their higher arbitrage costs. Controlling for limits to arbitrage proxies reduces the strength of the negative relation between delta-hedged option return and idiosyncratic volatility by about 40%.

Term Structure of Credit Default Swap Spreads and Cross-Section of Stock Returns

The slope of a firm's term structure of credit default swap (CDS) spreads (five-year spread minus one-year spread) negatively predicts future stock returns. Stocks with low CDS slope on average outperform stocks with high CDS slope by over 1% each month for the next six months. Our result can not be explained by standard risk factors, stock characteristics, default risk measures or changes in CDS spreads. We find that CDS slope positively predicts future changes in CDS spreads, but the information content of CDS slope only slowly gets incorporated into stock price. CDS slope predicts return mainly for stocks facing high arbitrage costs.

Dissecting the Profitability Premium

Previous studies show that the profitability-based factor can explain almost all asset pricing anomalies, highlighting the importance of firm profitability. This paper investigates both risk-based and behavioral-based explanations of the profitability premium itself. First, we show that the traditional macro risk is unlikely to be the source of the observed profitability premium. Second, the profitability premium exists primarily among firms with high arbitrage costs or high information uncertainty, and the majority of this premium is derived from the negative alpha of low profitability firms, consistent with the notion that overpricing is more prevalent than underpricing due to greater impediments to short. Third, we investigate the pattern of profitability premium at different holding horizons and find little evidence on long-run reversal, suggesting that the profitability premium is more likely to be related to underreaction, rather than ex-post overreaction. Finally, we compare three leading behavioral theories of over- and underreaction based on their different implications on the profitability premium, and our results suggest that inattention-induced underreaction is most plausible.

The dispersion effect in international stock returns

Abstract We find that stocks exhibiting high dispersion in analysts' earnings forecasts not only underperform in the U.S. but also in some European countries. Investigating the abnormal returns generated by the dispersion strategy around the world for the 1990–2008 sample period, we observe that the returns of the strategy are uneven, with large abnormal returns realized during the mid-to-late 1990s and the 2000–2003 period. In particular, we document that the dispersion effect is most profitable in a very narrow time frame around the burst of the technology bubble. As a consequence, the dispersion hedge strategy would have been rather difficult to implement, especially given that the highest mispricing obtains for stocks characterized by high arbitrage costs.