Prof. George Skiadopoulos - School of Economics and Finance, Queen Mary University of London
The Contribution of Mispricing to Expected Returns
We examine the contribution of stock mispricing to expected returns (CMER) within a financial intermediary equilibrium asset pricing model, where the market price of the stock deviates from its fundamental price due to frictions in the stock market. The stock's expected return consists of two parts: CMER and the risk-premium term determined by the covariance between the financial intermediaries' marginal utility of wealth and the stock return. We derive a model-free formula which enables us to compute CMER from equity options' prices. Our approach makes no assumptions on the source and dynamics of mispricing and it does not rely on a specific asset pricing model. The model predicts that CMER is positively related to future stock returns, CMER is a model-free alpha, and the variation of CMER is larger when transaction costs are larger. We document that these predictions hold for a large cross-section of U.S. common stocks. We also show that CMER relates to other popular option-implied measures of mispricing and hence we explain theoretically why these measures have been found to predict stock returns.