Disentangling Anomalies: Risk versus Mispricing

Systematic mispricing primarily affects speculative stocks and tends to take the form of overpricing, predicting lower average returns. Because speculative stocks are typically deemed risky by rational models, failing to control for exposure to systematic mispricing can bias tests of risk-return tradeoffs. Controlling for the effects of systematic mispricing, we recover robust positive risk-return relations for a large number of cross-sectional risk proxies, including many low-risk and distress anomalies. We also recover robust positive illiquidity-return relations. We provide a unifying framework to explain a number of puzzles arising from the empirical failure of standard asset-pricing models and show that risk-return relations supporting rational models can be recovered from the data by accounting for the existence of time-varying common mispricing.