The Social Welfare of Stock Market Mispricing

59 Pages Posted: 1 Dec 2023 Last revised: 24 Mar 2024

See all articles by Shikun Ke

Shikun Ke

Yale School of Management

Date Written: December 19, 2022

Abstract

This paper studies the social value of eliminating mispricing in the US stock markets. By characterizing a model in which active managers extract abnormal value by trading against mispricing, I show that the mispricing of a stock, relative to a benchmark asset pricing model, exactly equals to the marginal social value of mispricing trading. I further show how to use time-series alphas to compute mispricing and welfare gain from eliminating mispricing. Combining conditional mispricing estimates from a novel instrumented factor model and a calibrated price impact function, I find that the mispricing relative to CAPM translates into a welfare cost of about 3.1% of annual nominal GDP in the US, and increases to more than 8% during the Tech Bubble, the Global Financial Crisis, and in the recent Covid pandemic. These results suggest a large potential welfare gain from active management that eliminates stock mispricing.

Keywords: Mispricing, Welfare, Price Impact, CAPM, Instrumented Factor Model

JEL Classification: G10, G12, G14, G17

Suggested Citation

Ke, Shikun, The Social Welfare of Stock Market Mispricing (December 19, 2022). Available at SSRN: https://ssrn.com/abstract=4644775 or http://dx.doi.org/10.2139/ssrn.4644775

Shikun Ke (Contact Author)

Yale School of Management ( email )

165 Whitney Ave
New Haven, CT 06511

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