The Contribution of Frictions to Expected Returns

Abstract

We derive a model-free formula to estimate the contribution of market frictions to expected returns (CFER) within a formal asset pricing setting. We document that CFER can be estimated accurately by properly scaled deviations from put-call parity. CFER is sizable, it predicts stock returns and it has superior properties than previously proposed measures of deviations from put-call parity. We find that its predictive power stems from capturing the effect of market frictions, rather than from omitted factors and informed trading. Our findings suggest that market frictions, especially transaction costs, have a sizable effect even on large optionable stocks.

Keywords: Asset pricing, Implied volatility spread, Limits of arbitrage, Market frictions, Put-call parity, Return predictability

JEL Classification: C13, G12, G13