Do limits to arbitrage and mispricing explain belief heterogeneity? Evidence from an emerging market

Abstract

This study aims to examine whether mispricing and limits to arbitrage explain belief heterogeneity in the Tunisian stock market, while accounting for investor sentiment in an emerging market context. Using portfolio sorting and Fama–MacBeth regressions, this study analyzes stock returns from July 2007 to July 2018. It proposes a new trading–volume-based measure of belief heterogeneity and uses multiple proxies for limits to arbitrage and investor sentiment. The results show that stocks with high belief heterogeneity earn lower expected returns. Limits to arbitrage and investor sentiment do not significantly moderate this relationship. However, belief heterogeneity has a stronger effect on undervalued stocks than on overvalued stocks, providing new evidence beyond traditional overvaluation-based explanations. The study is limited by its focus on the Tunisian stock market, and the findings may not be generalizable to markets with different institutional structures and investor behaviors. The findings provide useful insights for investors and regulators seeking to better understand how belief heterogeneity and market frictions affect stock returns in emerging markets. This study contributes to the literature by developing a novel measure of belief heterogeneity and by providing new empirical evidence on the joint role of mispricing and arbitrage constraints in an emerging market setting.