A One-factor Model for Expected Night-minus-day Stock Returns

Abstract

We propose a one-factor model for expected night-minus-day (NMD) returns and use it to examine the economic forces underlying NMD return predictabilities. Our model successfully prices a large set of NMD portfolios with a cross-sectional R2 around 80%. Consistent with the absence of near-arbitrage opportunities, the pricing factor has substantial exposure to the dominant common risks in the NMD return space. Finally, we link the pricing factor to retail order imbalances at the market open and the required returns from liquidity provision. Our findings point to a pricing equilibrium in which liquidity providers require compensation for accommodating sentiment-driven demand.

Keywords: Night-minus-day returns, liquidity provision, limits-of-arbitrage, retail trading

JEL Classification: G12, G14, G23