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Limits of arbitrage and idiosyncratic volatility: Evidence from China stock market

Author

Listed:
  • Gu, Ming
  • Kang, Wenjin
  • Xu, Bu
Abstract
This study examines how limits of arbitrage can affect the pricing of idiosyncratic volatility. Using both unique trading constraints in the Chinese stock market and other commonly-used limits-of-arbitrage measures, we construct a comprehensive limits-of-arbitrage index. Based on this index, we find that the negative idiosyncratic volatility return premium is much stronger and more persistent in stocks with high limits of arbitrage. Furthermore, the existing explanations about the idiosyncratic volatility return premium cannot fully explain what we find about the role of limits of arbitrage in the pricing of idiosyncratic volatility in the Chinese stock market. Our study suggests that the trading constraints introduced in the name of protecting individual investors can actually hurt them, since these additional limits of arbitrage will increase the inefficiency of the security market.

Suggested Citation

  • Gu, Ming & Kang, Wenjin & Xu, Bu, 2018. "Limits of arbitrage and idiosyncratic volatility: Evidence from China stock market," Journal of Banking & Finance, Elsevier, vol. 86(C), pages 240-258.
    • Handle: RePEc:eee:jbfina:v:86:y:2018:i:c:p:240-258
    DOI: 10.1016/j.jbankfin.2015.08.016
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    More about this item

    Keywords

    Limits of arbitrage; Idiosyncratic volatility; China stock market;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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