Market Frictions, Price Delay, and the Cross-Section of Expected Returns

Abstract

We parsimoniously characterize the severity of market frictions affecting a stock using the delay with which its price responds to information. The most delayed firms command a large return premium not explained by size, liquidity, or microstructure effects. Moreover, delay captures part of the size effect, idiosyncratic risk is priced only among the most delayed firms, and earnings drift is monotonically increasing in delay. Frictions associated with investor recognition appear most responsible for the delay effect. The very small segment of delayed firms, comprising only 0.02% of the market, generates substantial variation in average returns, highlighting the importance of frictions. Predictability in the cross-section of returns fuels much of the market efficiency debate. Whether this predictability is due to mismeasurement of risk or constitutes an efficient market anomaly remains unresolved. Complicating this debate is the fact that traditional asset pricing theory assumes markets are frictionless and complete and assumes investors are well diversified. However, ample empirical evidence demonstrates the existence of sizeable market frictions and large groups of poorly diversified investors.