Arbitrage Risk and the Book-to-Market Anomaly

This paper shows that the book-to-market (B/M) effect is greater for stocks with higher idiosyncratic return volatility, higher transaction costs and lower investor sophistication, consistent with the market mispricing explanation for the anomaly. The B/M effect for high volatility stocks exceeds that for the low volatility stocks in 20 of the 22 sample years. Also, volatility exhibits significant incremental power beyond the transaction costs and investor sophistication measures in explaining cross-sectional variation in the B/M effect. These findings are consistent with the Shleifer and Vishny (1997) thesis that risk associated with the volatility of arbitrage returns deters arbitrage activity and is an important reason why the B/M effect exists