The Contribution of Frictions to Expected Returns
88 Pages Posted: 11 Feb 2018 Last revised: 10 Oct 2018
Date Written: October 5, 2018
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: Suggested Citation