Variation in Liquidity and Costly Arbitrage

This paper explores the relationship between variation in liquidity and mispricing. Mispricing is severe among stocks with high variation in liquidity. Among underpriced (overpriced) stocks, stocks with high variation in liquidity are more underpriced (overpriced). The mispricing is more pronounced during high investor sentiment periods. The results are not explained by the level of liquidity or idiosyncratic volatility. The evidence is consistent with variation in liquidity hindering arbitrage. Furthermore, the negative cross-sectional relationship between variation in liquidity and returns, documented in prior literature, disappears after accounting for the mispricing due to limited arbitrage