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Stock Market Mispricing: Money Illusion or Resale Option?

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  • Chen, Carl R.
  • Lung, Peter P.
  • Wang, F. Albert

Abstract

We examine two hypotheses to explain stock mispricing: i) the money illusion hypothesis (Modigliani and Cohn (1979)) and ii) the resale option hypothesis (Scheinkman and Xiong (2003)). We find that the money illusion hypothesis may explain the level, but not the volatility, of mispricing in the U.S. market. In contrast, the stock resale option hypothesis, which stems from heterogeneous beliefs about future dividend growth rates and short-sale constraints, can explain both the level and the volatility of mispricing. The evidence suggests that while the two hypotheses complement each other in explaining the level of mispricing, the resale option hypothesis provides a more coherent explanation for asset price bubbles, in which extraordinarily high price levels are often accompanied by excessive volatility and frenzied trading.

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  • Chen, Carl R. & Lung, Peter P. & Wang, F. Albert, 2009. "Stock Market Mispricing: Money Illusion or Resale Option?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(05), pages 1125-1147, October.
  • Handle: RePEc:cup:jfinqa:v:44:y:2009:i:05:p:1125-1147_99
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    Cited by:

    1. Liu, Dehong & Gu, Hongmei & Xing, Tiancai, 2016. "The meltdown of the Chinese equity market in the summer of 2015," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 504-517.
    2. Gwangheon Hong & Bong Lee, 2013. "Does Inflation Illusion Explain the Relation between REITs and Inflation?," The Journal of Real Estate Finance and Economics, Springer, vol. 47(1), pages 123-151, July.
    3. Acker, Daniella & Duck, Nigel W., 2013. "Inflation illusion and the US dividend yield: Some further evidence," Journal of International Money and Finance, Elsevier, vol. 33(C), pages 235-254.
    4. Tom Engsted & Thomas Q. Pedersen, 2016. "The predictive power of dividend yields for future infl?ation: Money illusion or rational causes?," CREATES Research Papers 2016-11, Department of Economics and Business Economics, Aarhus University.
    5. repec:kap:jrefec:v:55:y:2017:i:3:d:10.1007_s11146-016-9587-7 is not listed on IDEAS
    6. Chen, Sichong, 2012. "The predictability of aggregate Japanese stock returns: Implications of dividend yield," International Review of Economics & Finance, Elsevier, vol. 22(1), pages 284-304.

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