Mispricing in linear asset pricing models

Qiang Kang

Applied Economics, 2025, vol. 57, issue 11, 1196-1220

Abstract: In the framework of a reduced-form asset pricing model featuring linear-in-instrument betas and time-varying risk premiums and allowing for missing factors, I propose a measure of mispricing that is largely free from the bias due to missing factors or missing instruments. Applying the model to U.S. equity data, I find evidence of mispricing in stock returns. A mispricing-based zero-dollar investment strategy intersecting momentum and contrarian horizons is highly profitable when applied to both firm- and portfolio-level returns, even after controlling for Fama-French factors, momentum and liquidity effects. Focusing on momentum, I find that the phenomenon is partially caused by the mispricing that does not vary with macro variables. Time-varying betas reduce the mispricing by 40% or better.

Date: 2025
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DOI: 10.1080/00036846.2024.2311733

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