The impact of transaction costs on state-contingent claims mispricing

Restocchi, Valerio, Mcgroarty, Frank, Gerding, Enrico and Johnson, Johnnie (2017) The impact of transaction costs on state-contingent claims mispricing. Finance Research Letters. (doi:10.1016/j.frl.2017.02.006).

Record type: Article

Abstract

We analyze the impact that transaction costs have on asset mispricing in state-contingent claims markets. In particular, we examine betting markets,in which, it has been argued, transaction costs cause the favorite-longshot
bias, a pricing anomaly analogous to the volatility smile in options markets.By using a heterogeneous agents model, we prove that transaction costs alone cannot cause mispricing. Also, we run agent-based simulations to characterize the response of market prices to increments in transaction costs. We find that transaction costs have a significant impact on market inefficiency, by amplifying existing mispricing both directly, influencing market prices, and indirectly, inducing a non-linear response from the agents

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