Frequent, yet uninformed, market timing recommendations by a financial advisory firm generate significant flows for Chilean pension funds. These flows induce substantial changes in the Chilean foreign exchange rate due to the funds’ high allocation to international securities. Local banks provide liquidity to pension funds in the spot market and their hedging transactions propagate the demand fluctuations from the spot to the forward market, resulting in deviations from covered interest rate parity. Using bank balance sheet data, we confirm that banks’ risk bearing constraints create limits to arbitrage

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default have abnormally low average future returns. We show that firms with a high potential for default (death) also tend to have a relatively high probability of extremely large (jackpot) payoffs. Consistent with an investor preference for skewed, lottery-like payoffs, stocks with high predicted probabilities for jackpot returns earn abnormally low average returns. Stocks with high death or jackpot probabilities have relatively low institutional ownership and the jackpot effect we find is much stronger in stocks with high limits to arbitrage

Firms with higher asset growth rates subsequently experience lower stock returns in international equity markets, consistent with the U.S. evidence. This negative effect of asset growth on returns is stronger in more developed capital markets and markets where stocks are more efficiently priced, but is unrelated to country characteristics representing limits to arbitrage, investor protection, and accounting quality. The evidence suggests that the cross-sectional relation between asset growth and stock return is more likely due to an optimal investment effect than due to overinvestment, market timing, or other forms of mispricing

By applying machine learning to the accurate and cost-effective classification of photos based on sentiment, we introduce a daily market-level investor sentiment index (Photo Pessimism) obtained from a large sample of news photos. Consistent with behavioral models, Photo Pessimism predicts market return reversals and trading volume. The relation is strongest among stocks with high limits to arbitrage and during periods of elevated fear. We examine whether Photo Pessimism and pessimism embedded in news text act as complements or substitutes for each other in predicting stock returns and find evidence that the two are substitutes

This paper shows the cross-sectional and time series momentum in currencies, which cannot be explained by carry and dollar factors, summarize the autocorrelation of these factors. These momentum strategies long currency factors following positive factor returns and short them following losses. Carry and dollar factors are strongly autocorrelated and only earn significantly positive excess returns following positive factor returns. By contrast, idiosyncratic currency returns contain little momentum. Consequently, factor momentum not only outperforms the cross-sectional and time series momentum but also explains them. Limits to arbitrage and time-varying risk premium help explain factor momentum

We study the cross-section of returns on FX options sorting currencies based on implied volatilities (IVs). Long straddle positions in currencies with low (high) IVs perform well (poorly). A long low IV-short high IV strategy produces large average returns after transaction costs. Total volatility matters rather than any component or transformation of volatility. The returns are distinct from those in the literature on foreign exchange returns or equity option returns and cannot be explained convincingly by standard risk factors. We argue cross-sectional differences in hedging demand combined with limits to arbitrage contribute to mispricing in FX options

We present evidence on the asset pricing implications of salience theory. In our model, investors overweight salient past returns when forming expectations about future returns. Consequently, investors are attracted to stocks with salient upsides, which are overvalued and earn low subsequent returns. Conversely, stocks with salient downsides are undervalued and yield high future returns. We find empirical support for these predictions in the cross section of US stocks. The salience effect is stronger among stocks with greater limits to arbitrage and during high-sentiment periods. Our results are not explained by common risk factors, return reversals, lottery demand, and attention-grabbing news events

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

To short a stock, an arbitrageur must first borrow it. This paper describes the market for borrowing and lending U.S. equities, emphasizing the conditions generating and sustaining short-sale constraints. A large institutional lending intermediary provided eighteen months (4/2000–9/2001) of data on loan supply (“shortability”), loan fees (“specialness”), and loan recalls. The data suggest that while loan market specials and recalls are rare on average, the incidence of these short-sale constraints is increasing in the divergence of opinion among investors. Beyond some threshold, investor optimism itself can limit arbitrage via the loan market mechanism

This paper shows that leading theories of the beta anomaly fail to explain the anomaly’s conditional performance. Abnormal returns and Sharpe ratios of betting-against-beta (BAB) factors rise following months with below-median realized volatility, even controlling for mispricing, limits to arbitrage, lottery preferences, analyst disagreement, and sentiment. Moreover, the leverage constraints theory counterfactually predicts that market and BAB Sharpe ratios increase with volatility. We further show that institutional investors shift their demand from high- to low-beta stocks as volatility increases, and the resulting price impact is sufficient to explain the difference in abnormal BAB returns between high- and low-volatility states