Systematic Mispricing

We provide statistical estimates of individual security mispricing which is defined as the departure of the market price from the prediction of a fundamental asset pricing model. We show that there is a return premium associated with systematic mispricing risk which is the dependence of the individual security mispricing on a market wide mispricing factor. The risk or characteristic-adjusted return spread between high and low mispricing risk decile portfolios is 50-70 bp per month depending on the specification of the market mispricing factor. When portfolios are formed on estimates of both systematic mispricing risk and the liquidity betas of Amihud (2002), Pastor-Stambaugh (2003) or Liu (2006) there is evidence of a significant risk-adjusted return spread associated with systematic mispricing risk, but no longer any evidence of a systematic liquidity risk premium. When portfolios are formed using estimates of the mispricing return bias of Brennan and Wang (2007) and systematic mispricing risk, both characteristics are shown to contribute to the return premium.