The Mispricing Return Premium

We show that, when stock prices are subject to stochastic mispricing errors, expected rates of return may depend not only on the fundamental risk that is captured by a standard asset pricing model, but also on the type and degree of asset mispricing, even when the mispricing is zero on average. Empirically, the mispricing induced return premium, either estimated using a Kalman filter or proxied by the volatility and variance ratio of residual returns, is shown to be significantly associated with realized risk-adjusted returns. (JEL G10, G12) In this article we consider the implications of Jensen’s inequality for stock prices and expected rates of return in markets that are less than perfectly ef-ficient. In particular, we show that, for securities that are subject to stochas-tic mispricing relative to a given equilibrium asset pricing model, it is likely that either their prices will fail to be unconditionally rational or their returns will fail to be unconditionally rational, or both. By unconditionally rational prices we mean prices whose unconditional expectations are consistent with the fundamental asset pricing model, and by unconditionally rational return