I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. It features a flexible and tractable affine structure for bond covariances. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid–ask spread. Furthermore, market prices of interest rate caps do not deviate significantly from their no‐arbitrage values implied by the swaptions under the model. These findings support the conjectures of Collin‐Dufresne and Goldstein (2003) , Dai and Singleton (2003) , and Jagnnathan, Kaplin, and Sun (2003

This paper documents a close link between mispricing and liquidity by investigating stocks with high analyst disagreement. Previous research finds that these stocks tend to be overpriced, but that prices correct downwards as uncertainty about earnings is resolved. Our analysis suggests that one reason mispricing has persisted through the years is that analyst disagreement coincides with high trading costs. We also show that in the cross‐section, the less liquid stocks tend to be more severely overpriced. Additionally, increases in aggregate market liquidity accelerate the convergence of prices to fundamentals. As a result, returns of the initially overpriced stocks are negatively correlated with the time series of innovations in aggregate market liquidity