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The Contribution of Frictions to Expected Returns

Author

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  • Kazuhiro Hiraki

    (Queen Mary University of London)

  • George Skiadopoulos

    (Queen Mary University of London)

Abstract

We derive a model-free option-based formula to estimate the contribution of market frictions to expected returns (CFER) within an asset pricing setting. We estimate CFER for the U.S. optionable stocks. We document that CFER is sizable, it predicts stock returns and it subsumes the effect of frictions on expected returns as expected theoretically. The sizable alpha of a long-short portfolio formed on CFER is consistent with the size of market frictions and it is not due to model mis-specification. Moreover, we show that various option-implied measures proxy CFER, thus providing a theoretical explanation for their ability to predict stock returns.

Suggested Citation

  • Kazuhiro Hiraki & George Skiadopoulos, 2018. "The Contribution of Frictions to Expected Returns," Working Papers 874, Queen Mary University of London, School of Economics and Finance.
    • Handle: RePEc:qmw:qmwecw:874
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    File URL: https://www.qmul.ac.uk/sef/media/econ/research/workingpapers/2018/wp874.pdf
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    More about this item

    Keywords

    Alpha; Asset pricing; Implied volatility spread; Limits of arbitrage; Market frictions; Return predictability;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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