Levered Noise and the Limits of Arbitrage Pricing : Implications for the Term Structure of Equity Risk Premia

We show theoretically and empirically that no-arbitrage pricing magnifies the importance of noise when replication requires offsetting positions with similar fundamentals. This occurs because fundamentals are hedged, while any errors in the underlying asset prices are levered and amplified. Levered noise causes bias in estimated return moments including means, variances, and autocorrelations. We illustrate these effects in pairs trading strategies and in the highly levered portfolios required to replicate dividend strips. To improve estimates of the term structure of equity risk premia, we develop replication methods that reduce noise, focus on statistics that are more robust to noise, and provide time series that are longer than any prior study. The improved estimates provide no evidence of a downward sloping unconditional equity term structure. In the longest samples, dividend strip returns are lower than the market index