Turning Alphas into Betas: Arbitrage and the Cross-section of Risk

What determines the cross-section of betas with respect to a risk factor? The act of arbitrage plays an important role. If the capital of arbitrageurs loads on a systematic factor, the assets traded by the arbitrageurs gain different sensitivities to that factor, depending on the asset positions taken by the arbitrageurs. I develop predictions about such “arbitrage-driven” betas in a model of constrained arbitrage and test them in the cross-section of equity anomalies. The arbitrage channel accounts for a substantial part of the cross-sectional variation in equity anomalies’ betas in intermediary-based and multifactor asset pricing models.

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