Leverage and the Limits of Arbitrage Pricing: Implications for Dividend Strips and the Term Structure of Equity Risk Premia
36 Pages Posted: 21 Sep 2011 Last revised: 7 May 2013
Date Written: September 26, 2012
Negligible pricing frictions in underlying asset markets can become greatly magnified when using no-arbitrage arguments to price derivative claims. Amplification occurs when a replicating portfolio contains partially offsetting positions that lever up exposures to primary market frictions, and can cause arbitrarily large biases in synthetic return moments. We show theoretically and empirically how synthetic dividend strips, which shed light on the pricing of risks at different horizons, are impacted by this phenomenon. Dividend strips are claims to dividends paid over future time intervals, and can be replicated by highly levered long-short positions in futures contracts written on the same underlying index, but with different maturities. We show that tiny pricing frictions can help to reproduce a downward-sloping term structure of equity risk premia, excess volatility, return predictability, and a market beta substantially below one, consistent with empirical evidence. Using more robust return measures we find smaller point estimates of the returns to short-term dividend claims, and little support for a statistical or economic difference between the returns to short- versus long-term dividend claims.
Keywords: equity risk premium, dividend strips, term structure of equity risk premia, limits to arbitrage, microstructure frictions
JEL Classification: G12
Suggested Citation: Suggested Citation