Asset Pricing with Price Levels
74 Pages Posted: 28 Dec 2019 Last revised: 8 Sep 2020
Date Written: November 18, 2019
We propose a novel way to study asset prices based on price distortions rather than abnormal returns. We derive the correct identity linking current mispricing to subsequent returns, generating a price-level analogue to the fundamental asset pricing equation used to study returns. Our GMM test reveals that the CAPM describes the cross-section of prices noticeably better than it describes expected short horizon returns. Despite the improvement, significant mispricing remains. We show that book-to-market, quality, and size provide a parsimonious model of CAPM mispricing that both long-term buy-and-hold investors and researchers disciplining models from the price perspective should prioritize.
Keywords: price level, long-horizon returns, mispricing metric, stochastic discount factor, CAPM
JEL Classification: G12, G14, G32
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