Asset Pricing and Mispricing

In this paper we develop models for stock returns when stock prices are subject to stochastic mispricing errors. We show that expected rates of return 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 bias, proxied either by Kalman filter estimates or by volatility and variance ratio of residual returns, are shown to be significantly associated with realized risk adjusted returns