MARKET VOLATILITY , MARKET FRICTIONS , AND THE CROSS-SECTION OF STOCK RETURNS

We study a 3-factor asset-pricing model with market returns, (innovations in) market volatility, and (innovations in) market friction volatility. Market friction volatility is de…ned as the volatility of the di¤erence between observed asset prices and fundamental values. Both volatility components are extracted nonparametrically from a single time-series of high-frequency Standard and Poor’s depository receipts’(SPIDERS) trade prices. We …nd that market volatility and market friction volatility are negatively priced in the cross-section of daily and monthly 25 sizeand value-sorted Fama-French portfolios. In our sample, the performance of a 3-factor model with market return, market volatility, and market friction volatility is similar to the performance of the Fama-French 3-factor model when pricing these portfolios. JEL Classi…cation: G12

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