Costly arbitrage and the convergence of price to accounting fundamentals

This paper examines the impact of arbitrage costs on the level and duration of the disparity between price and accounting information about firm value. Arbitrage costs are expected to increase the disparity between price and value. However, by increasing the potential rewards to the arbitrageur, arbitrage costs may not necessarily impede the longer-term convergence of price to value. I use the residual income value-to-price ratio (vp) to measure the disparity between price and accounting based value. Consistent with expectations, I find that arbitrage costs are negatively associated with the level of vp (where lower levels of vp are an indication of overpricing). When I examine the duration of the disparity I find that arbitrage costs generally decrease the amount of time that price and value are disparate from their long-term relation. My results are consistent with risk-averse arbitrageurs delaying their trades until mispricing can be profitably and rapidly removed.