We show that idiosyncratic jumps are a key determinant of mean stock returns from both an ex post and ex ante perspective. Ex post, the entire annual average return of a typical stock accrues on the four days on which its price jumps. Ex ante, idiosyncratic jump risk earns a premium: a value-weighted weekly long-short portfolio that buys (sells) stocks with high (low) predicted jump probabilities earns annualized mean returns of 9.4% and four-factor alphas of 8.1%. This strategy’s returns are larger when there are greater limits to arbitrage. These results are consistent with investor aversion to idiosyncratic jump risk

Among high active share portfolios—whose holdings differ substantially from their benchmark—only those with patient investment strategies (with holding durations of over two years) on average outperform, over 2% per year. Funds trading frequently generally underperform, including those with high active share. Among patient funds, separating closet index from high active share funds matters, as low active share funds on average underperform even with patient strategies. Our results suggest that U.S. equity markets provide opportunities for longer-term active managers, perhaps because of the limited arbitrage capital devoted to patient and active investment strategies. The Online Appendix is available at http://ssrn.com/abstract=2810798

This paper investigates the impact of unconventional monetary policy on firm financial constraints using the maturity extension program (MEP). Consistent with bond market segmentation and limits to arbitrage, around the MEP's announcement, stock prices rose for those firms more dependent on longer-term debt. These firms also issued more long-term debt during the MEP and expanded employment and investment. There is also evidence of “reach for yield” behavior, as the demand for riskier corporate debt also increased. Our results suggest that unconventional monetary policy might have relaxed financial constraints for some firms by inducing gap-filling behavior and affecting bond market risk premia

Deviations from covered interest rate parity (CIP) are often linked to limits to arbitrage, yet trading volumes surge during periods of apparent no-arbitrage violations. We show that these distortions stem from constraints on non-U.S. agents’ access to wholesale U.S. dollar markets and reflect a premium for unencumbered synthetic dollar funding: non-U.S. banks substitute secured USD borrowing with FX swaps to meet regulatory requirements. A shadow cost-augmented CIP condition holds, implying no riskless arbitrage. U.S. dealers extract rents on dollar provision while non-U.S. customers bear $10.4 billion in additional annual hedging costs. Our results illustrate how intermediary constraints segment global dollar funding

Motivated by the theory of demand-based option pricing in imperfect markets, we examine the relation between short-sale constraints and equity option returns, conditional on the level of mispricing in the underlying stock. We report a monotonic relation between various measures of short-sale constraints and delta-hedged returns of put options on overpriced stocks. This relation is robust to controls for firm attributes and limits to arbitrage proxies. Our findings suggest that while investors drive up the demand for these put options, dealers command a high premium as compensation for the increased market making risk. We do not find a robust relation for either put options on underpriced stocks or call options

We provide a broad empirical investigation of momentum strategies in the foreign exchange market. We find a significant cross-sectional spread in excess returns of up to 10% per annum (p.a.) between past winner and loser currencies. This spread in excess returns is not explained by traditional risk factors, it is partially explained by transaction costs and shows behavior consistent with investor under- and overreaction. Moreover, cross-sectional currency momentum has very different properties from the widely studied carry trade and is not highly correlated with returns of benchmark technical trading rules. However, there seem to be very effective limits to arbitrage that prevent momentum returns from being easily exploitable in currency markets

We examine institutional demand prior to well-known stock return anomalies and find that institutions have a strong tendency to buy stocks classified as overvalued (short leg of anomaly), and that these stocks have particularly negative ex post abnormal returns. Our results differ from numerous studies documenting a positive relation between institutional demand and future returns. We trace the difference to measurement horizon. We too find a positive relation at a quarterly horizon. However, the relation turns strongly negative at the one-year horizon used in anomaly studies. We consider several explanations for institutions’ tendency to trade contrary to anomaly prescriptions. Our evidence largely rules out explanations based on flow and limits-of-arbitrage, but is more consistent with agency-induced preferences for stock characteristics that relate to poor long-run performance

We study an economy populated by three groups of myopic agents: constrained agents subject to a portfolio constraint that limits their risk taking, unconstrained agents subject to a standard nonnegative wealth constraint, and arbitrageurs with access to a credit facility. Such credit is valuable as it allows arbitrageurs to exploit the limited arbitrage opportunities that emerge endogenously in reaction to the demand imbalance generated by the portfolio constraint. The model is solved in closed-form, and we show that, in contrast to existing models with frictions and logarithmic agents, arbitrage activity has an impact on the price level and generates both excess volatility and the leverage effect. We show that these results are due to the fact that arbitrageurs amplify fundamental shocks by levering up in good times and deleveraging in bad times

This paper introduces a real-time, continuous measure of national sentiment that is language-free and thus comparable globally: the positivity of songs that individuals choose to listen to. This is a direct measure of mood that does not pre-specify certain mood-affecting events nor assume the extent of their impact on investors. We validate our music-based sentiment measure by correlating it with mood swings induced by seasonal factors, weather conditions, and COVID-related restrictions. We find that music sentiment is positively correlated with same-week equity market returns and negatively correlated with next-week returns, consistent with sentiment-induced temporary mispricing. Results also hold under a daily analysis and are stronger when trading restrictions limit arbitrage. Music sentiment also predicts increases in net mutual fund flows, and absolute sentiment precedes a rise in stock market volatility. It is negatively associated with government bond returns, consistent with a flight to safety

I develop a framework to analyze demand curves for multiple risky securities at extended horizons in a setting with limits-to-arbitrage. Following an unexpected change in uninformed investor demand for several assets, I predict returns of each security to be proportional to the contribution of that security's demand shock to the risk of a diversified arbitrage portfolio. I show that securities that are not affected by demand shocks but are correlated with securities undergoing changes in demand should experience returns related to their hedging role in arbitrageurs' portfolios. Finally, I predict a negative cross-sectional relation between post-event returns and the initial return associated with the change in demand. I confirm these predictions using data from a unique redefinition of the Nikkei 225 index in Japan, in which 255 stocks simultaneously undergo significant changes in index investor demand, causing more than ¥2,000 billion of trading in one week and large price changes followed by subsequent reversals for all of the reweighted stocks