Arbitrage, and Equilibrium Asset Pricing

This paper offers a model in which asset prices ref lect both covariance risk and misperceptions of firms ’ prospects, and in which arbitrageurs trade against mis-pricing. In equilibrium, expected returns are linearly related to both risk and mis-pricing measures ~e.g., fundamental0price ratios!. With many securities, mispricing of idiosyncratic value components diminishes but systematic mispricing does not. The theory offers untested empirical implications about volume, volatility, fundamental0price ratios, and mean returns, and is consistent with several empir-ical findings. These include the ability of fundamental0price ratios and market value to forecast returns, and the domination of beta by these variables in some studies. THE CLASSIC THEORY OF SECURITIES MARKET equilibrium beginning with Sharpe ~1964!, Lintner ~1965!, and Black ~1972! is based on the interaction of fully rational optimizing investors. In recent years, several important studies have explored alternatives to the premise of full rationality. On