Risky Arbitrage, Limits of Arbitrage, and Nonlinear Adjustment in the Dividend-Price Ratio

Liam Gallagher and Mark Taylor

Economic Inquiry, 2001, vol. 39, issue 4, 524-36

Abstract: We provide a simple test of two alternative views of arbitrage activity: the risky arbitrage hypothesis and the limits of arbitrage hypothesis. For the U.S., the speed of reversion of the market log dividend-price ratio towards the fundamental equilibrium is a nonlinear, increasing function of the degree of mispricing, providing evidence supporting the risky arbitrage hypothesis. Further research might concentrate on particular sectors where the risks of arbitrage are greatest and its effect is therefore likely to be weakest. Copyright 2001 by Oxford University Press.

Date: 2001
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