The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies
YONGQIANG CHU
Search for more papers by this authorDAVID HIRSHLEIFER
Search for more papers by this authorCorresponding Author
LIANG MA
Yongqiang Chu is with the Belk College of Business, University of North Carolina, Charlotte. David Hirshleifer is with the Merage School of Business, University of California at Irvine and NBER. Liang Ma is with the Darla Moore School of Business, University of South Carolina. For helpful comments and suggestions, we thank Wei Xiong (the editor); an anonymous associate editor; two anonymous referees; Karl Diether; Lukasz Pomorski; Jeffrey Pontiff; Lin Sun; and participants at the 2016 Rodney L. White Center for Financial Research Conference on Financial Decisions and Asset Markets at Wharton and the 2017 American Finance Association Meetings. This research has received financial support from the Moore School Research Grant Program. The authors have read The Journal of Finance disclosure policy and have no conflicts of interest to disclose.
Correspondence: Liang Ma, Department of Finance, Darla Moore School of Business, University of South Carolina, 1014 Greene Street, Columbia, SC 29208; e-mail: liang.ma@moore.sc.edu.
Search for more papers by this authorYONGQIANG CHU
Search for more papers by this authorDAVID HIRSHLEIFER
Search for more papers by this authorCorresponding Author
LIANG MA
Yongqiang Chu is with the Belk College of Business, University of North Carolina, Charlotte. David Hirshleifer is with the Merage School of Business, University of California at Irvine and NBER. Liang Ma is with the Darla Moore School of Business, University of South Carolina. For helpful comments and suggestions, we thank Wei Xiong (the editor); an anonymous associate editor; two anonymous referees; Karl Diether; Lukasz Pomorski; Jeffrey Pontiff; Lin Sun; and participants at the 2016 Rodney L. White Center for Financial Research Conference on Financial Decisions and Asset Markets at Wharton and the 2017 American Finance Association Meetings. This research has received financial support from the Moore School Research Grant Program. The authors have read The Journal of Finance disclosure policy and have no conflicts of interest to disclose.
Correspondence: Liang Ma, Department of Finance, Darla Moore School of Business, University of South Carolina, 1014 Greene Street, Columbia, SC 29208; e-mail: liang.ma@moore.sc.edu.
Search for more papers by this authorABSTRACT
We examine the causal effect of limits to arbitrage on 11 well-known asset pricing anomalies using the pilot program of Regulation SHO, which relaxed short-sale constraints for a quasi-random set of pilot stocks, as a natural experiment. We find that the anomalies became weaker on portfolios constructed with pilot stocks during the pilot period. The pilot program reduced the combined anomaly long–short portfolio returns by 72 basis points per month, a difference that survives risk adjustment with standard factor models. The effect comes only from the short legs of the anomaly portfolios.
Supporting Information
| Filename | Description |
|---|---|
| jofi12947-sup-0001-InternetAppendix.pdf268.8 KB | Appendix S1: Internet Appendix. |
| jofi12947-sup-0002-ReplicationCode.zip31.7 KB | Replication code. |
Please note: The publisher is not responsible for the content or functionality of any supporting information supplied by the authors. Any queries (other than missing content) should be directed to the corresponding author for the article.
REFERENCES
- Ali, Ashiq, Lee-Seok Hwang, and Mark A. Trombley, 2003, Arbitrage risk and the book-to-market anomaly, Journal of Financial Economics 69, 355–373.
- Ali, Ashiq, and Mark A. Trombley, 2006, Short sales constraints and momentum in stock returns, Journal of Business Finance & Accounting 33, 587–615.
- Asparouhova, Elena, Hendrik Bessembinder, and Ivalina Kalcheva, 2010, Liquidity biases in asset pricing tests, Journal of Financial Economics 96, 215–237.
- Asparouhova, Elena, Hendrik Bessembinder, and Ivalina Kalcheva, 2013, Noisy prices and inference regarding returns, Journal of Finance 68, 665–714.
- Asquith, Paul, Parag A. Pathak, and Jay R. Ritter, 2005, Short interest, institutional ownership, and stock returns, Journal of Financial Economics 78, 243–276.
- Baker, Malcolm, and Serkan Savaşoglu, 2002, Limited arbitrage in mergers and acquisitions, Journal of Financial Economics 64, 91–115.
- Barberis, Nicholas, and Richard Thaler, 2003, A survey of behavioral finance, in George M. Constantinides, Milton Harris, and René M. Stulz, eds.: Handbook of the Economics of Finance (North-Holland, Amsterdam).
- Beneish, Messod D., Charles MC Lee, and D. Craig Nichols, 2015, In short supply: Short-sellers and stock returns, Journal of Accounting and Economics 60, 33–57.
- Campbell, John Y., Jens Hilscher, and Jan Szilagyi, 2008, In search of distress risk, Journal of Finance 63, 2899–2939.
- Cao, Bing, Dan S. Dhaliwal, Adam C. Kolasinski, and Adam V. Reed, 2007, Bears and numbers: Investigating how short sellers exploit and affect earnings-based pricing anomalies, Working paper, University of Arizona, University of Washington, and University of North Carolina.
- Chen, Joseph, Harrison Hong, and Jeremy C. Stein, 2002, Breadth of ownership and stock returns, Journal of Financial Economics 66, 171–205.
- Chen, Long, Robert Novy-Marx, and Lu Zhang, 2011, An alternative three-factor model, Working paper, Washington University in St. Louis, University of Rochester, and Ohio State University.
- Cohen, Lauren, Karl B. Diether, and Christopher J. Malloy, 2007, Supply and demand shifts in the shorting market, Journal of Finance 62, 2061–2096.
- Cooper, Michael J., Huseyin Gulen, and Michael J. Schill, 2008, Asset growth and the cross-section of stock returns, Journal of Finance 63, 1609–1651.
- Daniel, Kent, and Sheridan Titman, 2006, Market reactions to tangible and intangible information, Journal of Finance 61, 1605–1643.
- D'Avolio, Gene, 2002, The market for borrowing stock, Journal of Financial Economics 66, 271–306.
- Dichev, Ilia D., 1998, Is the risk of bankruptcy a systematic risk? Journal of Finance 53, 1131–1147.
- Diether, Karl B., Kuan-Hui Lee, and Ingrid M. Werner, 2009, It's SHO time! Short-sale price tests and market quality, Journal of Finance 64, 37–73.
- Drechsler, Itamar, and Qingyi Freda Drechsler, 2014, The shorting premium and asset pricing anomalies, Working paper, New York University and Wharton Research Data Services.
- Engelberg, Joseph E., Adam V. Reed, and Matthew C. Ringgenberg, 2018, Short-selling risk, Journal of Finance 73, 755–786.
- Fama, Eugene F., and Kenneth R. French, 1992, The cross-section of expected stock returns, Journal of Finance 47, 427–465.
- Fama, Eugene F., and Kenneth R. French, 1993, Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33, 3–56.
- Fama, Eugene F., and Kenneth R. French, 2006, Profitability, investment and average returns, Journal of Financial Economics 82, 491–518.
- Fang, Vivian W., Allen H. Huang, and Jonathan M. Karpoff, 2016, Short selling and earnings management: A controlled experiment, Journal of Finance 71, 1251–1294.
- Geczy, Christopher C., David K. Musto, and Adam V. Reed, 2002, Stocks are special too: An analysis of the equity lending market, Journal of Financial Economics 66, 241–269.
- Gromb, Denis, and Dimitri Vayanos, 2010, Limits of arbitrage, Annual Review of Financial Economics 2, 251–275.
- Grullon, Gustavo, Sébastien Michenaud, and James P. Weston, 2015, The real effects of short-selling constraints, Review of Financial Studies 28, 1737–1767.
- Harvey, Campbell R., Yan Liu, and Heqing Zhu, 2016, … and the cross-section of expected returns, Review of Financial Studies 29, 5–68.
- Hirshleifer, David, 2001, Investor psychology and asset pricing, Journal of Finance 56, 1533–1597.
- Hirshleifer, David, Kewei Hou, Siew Hong Teoh, and Yinglei Zhang, 2004, Do investors overvalue firms with bloated balance sheets? Journal of Accounting and Economics 38, 297–331.
- Hirshleifer, David, Siew Hong Teoh, and Jeff Jiewei Yu, 2011, Short arbitrage, return asymmetry and the accrual anomaly, Review of Financial Studies 24, 2429–2461.
- Israel, Ronen, and Tobias J. Moskowitz, 2013, The role of shorting, firm size, and time on market anomalies, Journal of Financial Economics 108, 275–301.
- Jegadeesh, Narasimhan, and Sheridan Titman, 1993, Returns to buying winners and selling losers: Implications for stock market efficiency, Journal of Finance 48, 65–91.
- Jegadeesh, Narasimhan, and Sheridan Titman, 2001, Profitability of momentum strategies: An evaluation of alternative explanations, Journal of Finance 56, 699–720.
- Jones, Charles M., and Owen A. Lamont, 2002, Short-sale constraints and stock returns, Journal of Financial Economics 66, 207–239.
- Lam, F.Y. Eric C., and K.C. John Wei, 2011, Limits-to-arbitrage, investment frictions, and the asset growth anomaly, Journal of Financial Economics 102, 127–149.
- Lamont, Owen A., and Richard H. Thaler, 2003, Can the market add and subtract? Mispricing in tech stock carve-outs, Journal of Political Economy 111, 227–268.
- Li, Yinghua, and Liandong Zhang, 2015, Short selling pressure, stock price behavior, and management forecast precision: Evidence from a natural experiment, Journal of Accounting Research 53, 79–117.
- Loughran, Tim, and Jay R. Ritter, 1995, The new issues puzzle, Journal of Finance 50, 23–51.
- Mashruwala, Christina, Shivaram Rajgopal, and Terry Shevlin, 2006, Why is the accrual anomaly not arbitraged away? The role of idiosyncratic risk and transaction costs, Journal of Accounting and Economics 42, 3–33.
- Nagel, Stefan, 2005, Short sales, institutional investors and the cross-section of stock returns, Journal of Financial Economics 78, 277–309.
- Novy-Marx, Robert, 2013, The other side of value: The gross profitability premium, Journal of Financial Economics 108, 1–28.
- Ohlson, James A., 1980, Financial ratios and the probabilistic prediction of bankruptcy, Journal of Accounting Research 18, 109–131.
- Pontiff, Jeffrey, 1996, Costly arbitrage: Evidence from closed-end funds, Quarterly Journal of Economics 111, 1135–1151.
- Pontiff, Jeffrey, and Artemiza Woodgate, 2008, Share issuance and cross-sectional returns, Journal of Finance 63, 921–945.
- Reed, Adam V., 2013, Short selling, Annual Review of Financial Economics 5, 245–258.
- Saffi, Pedro A.C., and Kari Sigurdsson, 2010, Price efficiency and short selling, Review of Financial Studies 24, 821–852.
- Shleifer, Andrei, and Robert W. Vishny, 1997, The limits of arbitrage, Journal of Finance 52, 35–55.
- Sloan, Richard, 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289–315.
- Stambaugh, Robert F., Jianfeng Yu, and Yu Yuan, 2012, The short of it: Investor sentiment and anomalies, Journal of Financial Economics 104, 288–302.
- Titman, Sheridan, Kuo-Chiang Wei, and Feixue Xie, 2004, Capital investments and stock returns, Journal of Financial and Quantitative Analysis 39, 677–700.
