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Costly arbitrage and the convergence of price to accounting fundamentals: The role of idiosyncratic risk
Asher Curtis,
The University Of Utah
ABSTRACT. This paper examines the impact of arbitrage costs on the level and duration of the disparity between price and accounting-based value. Arbitrage costs are expected to increase the disparity between price and value. By increasing the potential rewards to the arbitrageur, however, arbitrage costs may not necessarily increase the duration of the disparity between price and value. I use the residual income value-to-price ratio (vp) to measure the disparity between price and accounting based value. I find that arbitrage costs are negatively associated with the level of vp (where lower levels of vp are an indication of overpricing). When I examine the duration of the disparity, I find mixed results. In general, arbitrage costs decrease the duration of the disparity between price and value, however, during the late 1990s this association is reversed. My results are consistent with risk-averse arbitrageurs delaying their trades until mispricing can be profitably and rapidly removed.
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