The Contribution of Frictions to Expected Returns

88 Pages Posted: 11 Feb 2018 Last revised: 10 Oct 2018

Kazuhiro Hiraki

Queen Mary, University of London, School of Economics and Finance

George S. Skiadopoulos

University of Piraeus; Queen Mary, University of London, School of Economics and Finance

Date Written: October 5, 2018

Abstract

We derive a model-free option-based formula to estimate the contribution of market frictions to expected returns (CFER) within an asset pricing setting. We estimate CFER for the U.S. optionable stocks. We document that CFER is sizable, it predicts stock returns and it subsumes the effect of frictions on expected returns as expected theoretically. The sizable alpha of a long-short portfolio formed on CFER is consistent with the size of market frictions and it is not due to model mis-specification. Moreover, we show that various option-implied measures proxy CFER, thus providing a theoretical explanation for their ability to predict stock returns.

Keywords: Alpha, Asset pricing, Implied volatility spread, Limits of arbitrage, Market frictions, Return predictability

JEL Classification: G11, G12, G13

Suggested Citation

Hiraki, Kazuhiro and Skiadopoulos, George, The Contribution of Frictions to Expected Returns (October 5, 2018). Available at SSRN: https://ssrn.com/abstract=3114764 or http://dx.doi.org/10.2139/ssrn.3114764

Kazuhiro Hiraki (Contact Author)

Queen Mary, University of London, School of Economics and Finance ( email )

Mile End Rd
Mile End Road
London, London E1 4NS
United Kingdom

George Skiadopoulos

University of Piraeus ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

HOME PAGE: http://web.xrh.unipi.gr/faculty/gskiadopoulos/

Queen Mary, University of London, School of Economics and Finance

Lincoln's Inn Fields
Mile End Rd.
London, E1 4NS
United Kingdom

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