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No. 874: The Contribution of Frictions to Expected Returns

Kazuhiro Hiraki , Queen Mary University of London
George Skiadopoulos , Queen Mary University of London

October 20, 2018

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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.

J.E.L classification codes: C13, G12, G13

Keywords:Alpha, Asset pricing, Implied volatility spread, Limits of arbitrage, Market frictions, Return predictability

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