Turning Alphas into Betas: Arbitrage and the Cross-section of Risk Thummim Cho∗ London School of Economics May 2018 Abstract What determines the cross-section of asset betas with a risk factor? Arbitrage activity plays an important role. I develop a model in which the cross-section of betas arises endogenously through the act of arbitrage. Testing the model’s predictions, I show empirically that arbitrage activity plays an important role in generating the cross-section of betas in multifactor and intermediary-based asset pricing models. The arbitrage channel for the betas can cause a cross-sectional asset pricing regression to suffer from endogeneity. ∗Department of Finance, London, UK. Email:
[email protected]. I thank my advisors John Campbell, Jeremy Stein, Samuel Hanson, and Adi Sunderam for their outstanding guidance and support, and Andrei Shleifer for many insightful discussions. I also thank Tobias Adrian, Lauren Cohen, William Diamond, Erkko Etula, Wayne Ferson, Robin Greenwood, Valentin Haddad, Byoung-Hyoun Hwang, Christian Julliard, Yosub Jung, Dong Lou, Chris Malloy, Ian Martin, David McLean, Tyler Muir, Christopher Polk, Emil Siriwardane, Argyris Tsiaras, Dimitry Vayanos, Yao Zeng, and seminar participants at the Adam Smith Asset Pricing Workshop, Boston College, Columbia Business School, Cornell University, Dartmouth College, Harvard Business School, London School of Economics, University of British Columbia, University of Southern California, Hanyang University, Korea University, and Seoul National University for helpful discussions and comments. Robert Novy-Marx and Mihail Velikov generously allowed me to use their data on anomalies for preliminary empirical analyses. Jonathan Tan, Karamfil Todorov, and Yue Yuan provided superb research assistance.