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Stock Market Mispricing: Money Illusion or Resale Option?

Published online by Cambridge University Press:  01 October 2009

Carl R. Chen ,
Peter P. Lung  and
F. Albert Wang
Carl R. Chen
Affiliation:
School of Business Administration, University of Dayton, 300 College Park, Dayton, OH 45469. chen@udayton.edu
Peter P. Lung
Affiliation:
College of Business, University of Texas at Arlington, Box 19366, Arlington, TX 76019. lungpeip@uta.edu
F. Albert Wang
Affiliation:
School of Business Administration, University of Dayton, 300 College Park, Dayton, OH 45469. albert.wang@udayton.edu
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Abstract

We examine two hypotheses to explain stock mispricing: i) the money illusion hypothesis (Modigliani and Cohn (1979)) and ii) the resale option hypothesis (Scheinkman and Xiong (2003)). We find that the money illusion hypothesis may explain the level, but not the volatility, of mispricing in the U.S. market. In contrast, the stock resale option hypothesis, which stems from heterogeneous beliefs about future dividend growth rates and short-sale constraints, can explain both the level and the volatility of mispricing. The evidence suggests that while the two hypotheses complement each other in explaining the level of mispricing, the resale option hypothesis provides a more coherent explanation for asset price bubbles, in which extraordinarily high price levels are often accompanied by excessive volatility and frenzied trading.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 5 , October 2009 , pp. 1125 - 1147
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

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