Does Risk or Mispricing Explain the Cross-Section of Stock Prices

61 Pages Posted: 2 Mar 2002

See all articles by Randolph B. Cohen

Randolph B. Cohen

Harvard Business School - Finance Unit

Christopher Polk

London School of Economics

Tuomo Vuolteenaho

Arrowstreet Capital, LP; National Bureau of Economic Research (NBER)

Date Written: May 16, 2002

Abstract

Most previous research evaluates market efficiency and asset pricing models using average abnormal trading profits on dynamic trading strategies. We measure the ability of the capital asset pricing model (CAPM) and the efficient-market hypothesis to explain the level of stock prices. First, we find that cash-flow betas (measured by regressing firms' earnings on the market's earnings) explain the prices of value and growth stocks well, with a plausible premium. Second, we use a present-value model to decompose the cross-sectional variance of firms' price-to-book ratios into two components due to risk-adjusted fundamental value and mispricing. When we allow the discount rates to vary as predicted by the CAPM, the variance share of mispricing is negligible.

Keywords: stock prices, present value, book-to-market, variance decomposition, capital asset pricing model, beta, expected returns, return on equity

JEL Classification: G120, G140

Suggested Citation

Cohen, Randolph B. and Polk, Christopher and Vuolteenaho, Tuomo, Does Risk or Mispricing Explain the Cross-Section of Stock Prices (May 16, 2002). AFA 2003 Washington, DC Meetings; EFA 2002 Berlin Meetings Presented Paper; HBS Finance Working Paper No. 03-107. Available at SSRN: https://ssrn.com/abstract=301782 or http://dx.doi.org/10.2139/ssrn.301782

Randolph B. Cohen

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6674 (Phone)
617-496-6592 (Fax)

Christopher Polk

London School of Economics ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/polk/

Tuomo Vuolteenaho (Contact Author)

Arrowstreet Capital, LP ( email )

44 Brattle St., 5th Floor
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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