Investor Sentiment, Limited Arbitrage and the Cash Holding Effects

We examine the market mispricing and limits-to-arbitrage hypotheses on the positive relation between cash holdings and expected stock returns. Using investor sentiment as a proxy for market mispricing, we find that returns of cash holding stocks are heavily influenced by investor sentiment. Using transaction costs, institutional ownership and idiosyncratic volatility as proxies for limits-to-arbitrage, we show that the cash holding effects are strong among stocks with large transaction and short selling costs, and high idiosyncratic volatility. This indicates that high arbitrage costs and risks prevent arbitrageurs to eliminate the mispricing on the cash holding effects