Investigating the Limits-of-Arbitrage and Arbitrage Asymmetry on the Idiosyncratic Volatility Return Premium in the Tehran Stock Exchange

This study investigates the effects of arbitrage asymmetry and limits-of-arbitrage to explain the observed idiosyncratic volatility return premium in the Tehran Stock Exchange. The sample includes 90 companies listed on the Tehran Stock Exchange from 2008 to 2022. For this purpose, a comprehensive index of limits-of-arbitrage has been constructed based on three measures of arbitrage risk: transaction costs, noise trader risk, and information uncertainty. Furthermore, a mispricing measure has been constructed based on three anomalies: asset growth, gross profitability, and momentum. These measures and anomalies capture the main features of the Tehran Stock Exchange. To test the research hypothesis, the three-way portfolio sorting and the Fama-Macbeth cross-sectional regressions conducted. The empirical findings show that the idiosyncratic volatility premium is positive for both overpriced and underpriced stocks. Within the high limits-of-arbitrage stocks, the positive idiosyncratic volatility return premium is higher for overpriced stocks than for underpriced stocks. Consequently, the limits-of-arbitrage and the arbitrage asymmetry can explain the positive idiosyncratic volatility return premium in theTehran Stock Exchange.