Beta uncertainty as a barrier to arbitrage and the impact on anomaly returns

Abstract

Beta uncertainty creates unavoidable risk in exploiting anomalies, suggesting an unexplored barrier to arbitrage. We measure beta uncertainty from parameter dynamics and estimation risk, decoupling it from idiosyncratic risk in a Bayesian market model accommodating separate processes for beta and idiosyncratic volatility. Anomalies with higher beta uncertainty generate substantially higher returns. For individual stocks, beta uncertainty is found to reduce arbitrage activity directly, thereby enhancing mispricing. These results support the arbitrage hurdle mechanism versus other hypotheses regarding beta uncertainty. The uncovered arbitrage barrier provides new evidence supporting attribution of observed anomalies to mispricing that cannot be fully corrected by arbitrage.

Valuation Insight: The equity of firms with more beta uncertainty (uncertainty about their exposure to systematic risk) is more likely to be mispriced. The reason is that potential arbitrageurs are not able to transport alpha without incurring significant uncertainty about the quantity of systematic risk they will be facing in the process. For these firms, the discount rates in valuing their cash flows are mis specified and difficult to correct.