Cost : a possible explanation for risk premium?
Transaction costs, information costs and defaults costs are suspected to partially explain differences in returns which were previously attributed to risk premiums in the financial markets. Two portfolios with identical costs are constructed from a Put, a Call, and underlying S&P 500 stocks, with the first Portfolio being hedged (Put-Call Parity) and the second Portfolio being unhedged (with systematic beta close to 2). The expected stock prices of S&P 500 were calculated based on 52-year historical data using several methods, and returns of the two portfolios were obtained and compared, using 935 observations of S&P 500 from January 2, 1992 through June 30, 1992. A linear regression model adjusted for cross-sectional heteroskedasticity and auto-correlation was used to estimate the expected risk premium rate. Transaction, information and default costs were statistically significant and estimated at 0.6% of value annually. These costs reduce the risk premium estimated by the Capital Asset Pricing Model.