Market Frictions, Price Delay, and the Cross-Section of Expected Returns
Kewei Hou, Ohio State University
Tobias J. Moskowitz, University of Chicago

We parsimoniously characterize the severity of market frictions affecting a stock using the average delay with which its share price responds to information. The most severely delayed firms command a large return premium not explained by size, liquidity, other return premia, or microstructure effects. Moreover, delay captures part of the size effect and enhances the value premium. Idiosyncratic risk is priced only among the most delayed firms. Frictions associated with investor recognition appear most responsible for the impact of delay. The very small segment of delayed and neglected firms generates substantial cross-sectional variation in average returns, highlighting the importance of market frictions.

The results from this project will particularly interest our members who use momentum-based stock selection models and various arbitrage models. In particular, the results indicate where profits will most likely be found-at least in the past, and why various frictions might be related to profitable trading strategies.