Levered Noise and the Limits of Arbitrage Pricing: Implications for the Term Structure of Equity Risk Premia

52 Pages Posted: 21 Sep 2011 Last revised: 2 Apr 2019

See all articles by Oliver Boguth

Oliver Boguth

Arizona State University (ASU) - Finance Department

Murray Carlson

University of British Columbia (UBC) - Sauder School of Business

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business

Mikhail Simutin

University of Toronto - Rotman School of Management

Date Written: March 31, 2019

Abstract

We show theoretically and empirically that no-arbitrage pricing magnifies the importance of noise when replication requires offsetting positions with similar fundamentals. This occurs because fundamentals are hedged, while any errors in the underlying asset prices are levered and amplified. Levered noise causes bias in estimated return moments including means, variances, and autocorrelations. We illustrate these effects in pairs trading strategies and in the highly levered portfolios required to replicate dividend strips. To improve estimates of the term structure of equity risk premia, we develop replication methods that reduce noise, focus on statistics that are more robust to noise, and provide time series that are longer than any prior study. The improved estimates provide no evidence of a downward sloping unconditional equity term structure. In the longest samples, dividend strip returns are lower than the market index.

Keywords: equity risk premium, dividend strips, term structure of equity risk premia, limits to arbitrage, microstructure frictions

JEL Classification: G12

Suggested Citation

Boguth, Oliver and Carlson, Murray D. and Fisher, Adlai J. and Simutin, Mikhail, Levered Noise and the Limits of Arbitrage Pricing: Implications for the Term Structure of Equity Risk Premia (March 31, 2019). Available at SSRN: https://ssrn.com/abstract=1931105 or http://dx.doi.org/10.2139/ssrn.1931105

Oliver Boguth

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Murray D. Carlson

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8358 (Phone)

Adlai J. Fisher

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada
604-822-8331 (Phone)
604-822-4695 (Fax)

HOME PAGE: http://finance.sauder.ubc.ca/~fisher

Mikhail Simutin (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

HOME PAGE: http://www.rotman.utoronto.ca/simutin

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