Interaction between Investor Sentiment, Limits to Arbitrage and the Returns of Stock Market Anomalies : Evidence from the UK Stock Market

This study investigates the role of two prominent concepts in finance: the role of limits to arbitrage and investor sentiment on stock prices. The study examines how changes in market-wide investor sentiment and limits to arbitrage affect the performance of nine UK stock market anomalies. The existing literature relating to investor sentiment focuses mainly on the US stock market, whilst research on the UK market typically examines aggregated index-level data. In addition, previous studies tend to focus on examining investor sentiment and limits to arbitrage separately. Using data from UK-listed companies over the period January 1997 to December 2019, the study finds that five stock market anomalies are related to changes in UK investor sentiment and produce significantly higher returns following periods of high investor sentiment, while the effect of limits to arbitrage is mostly limited. However, the interaction analysis provides support to the limits to arbitrage theory and demonstrates that the effect of high investor sentiment on stock market anomalies is more pronounced when combined with high limits to arbitrage and has less effect during periods characterised by low limits to arbitrage