Idiosyncratic risk, costly arbitrage, and the cross-section of stock returns

Jie Cao (Corresponding Author), Bing Han

Research output: Journal article publicationJournal articleAcademic researchpeer-review

53 Citations (Scopus)


We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of costly arbitrage. If arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, there should be a positive (negative) relation between expected return and idiosyncratic risk for undervalued (overvalued) stocks. We combine several well-known anomalies to measure stock mispricing and proxy stock idiosyncratic risk using an exponential GARCH model for stock returns. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for undervalued (overvalued) stocks. Overall, our results support the importance of idiosyncratic risk as an arbitrage cost.

Original languageEnglish
Pages (from-to)1-15
Number of pages15
JournalJournal of Banking and Finance
Publication statusPublished - 1 Dec 2016
Externally publishedYes


  • Costly arbitrage
  • Idiosyncratic risk
  • Mispricing

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics


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