The purpose of this paper is to investigate the effect of the "limits of arbitrage" on securities mispricing. Specifically, I investigate the effect of the availability of substitutes and financial constraints on stock mispricing. In addition, this study investigates the difference in the limits of arbitrage, in the sense that it will lead to lower mispricing for these stocks, relative to non-S&P 500 stocks. I also examine if the lower mispricing can be attributed to their lower limits of arbitrage. Modern finance theory and efficient market hypothesis suggest that security prices, at equilibrium, should reflect their fundamental value. If the market price deviates from the intrinsic value, then a risk-free profit opportunity has emerged and arbitrageurs will eliminate mispricing and equilibrium is restored. This arbitrage process is characterized by large number of arbitrageurs which have infinite access to capital. However, a better description of reality is that there are few numbers of arbitrageurs to the extent that they are highly specialized; and they have limited access to capital. Under these condition arbitrage is no more a risk-free activity and can be limited by several factors such as arbitrage risk and transaction costs. Other factors that are discussed in the literature …

Issuers’ credit ratings change by one or more notches when credit rating agencies provide new ratings. Unique to the literature, I study the influences affecting multi notch versus single notch rating upgrades and downgrades. For Standard & Poors data, I show that rating changes with multiple notches provide more information to the market than single notch rating changes. Consistent with prior literature on the business cycle, I show that investors value good news rating changes (upgrades) more in bad times (recession) and that investors value bad news rating changes (downgrades) more in good times (expansion). I model and test probit models using variables capturing the characteristics of the previous issuer’s credit rating, liquidity, solvency, profitability, and growth opportunity to determine the classification of single notch versus multi notch rating changes. The determinants of multi notch versus single notch rating changes for upgrades and downgrades differ. Business cycle influences are evident. Firms that have multi notch rating upgrades and downgrades have significantly different probit variables vis-à-vis firms that have single notch rating upgrades and downgrades. The important characteristics for determining multiple notch upgrades are a firm’s prior rating change, prior rating, cash flow, total assets and market value. The important characteristics …