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

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: September 26, 2012

Abstract

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

Boguth, Oliver and Carlson, Murray D. and Fisher, Adlai J. and Simutin, Mikhail, Leverage and the Limits of Arbitrage Pricing: Implications for Dividend Strips and the Term Structure of Equity Risk Premia (September 26, 2012). 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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