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Idiosyncratic risk and the cross-section of stock returns: Merton (1987) meets Miller (1977)

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Author Info
Boehme, Rodney D.
Danielsen, Bartley R.
Kumar, Praveen
Sorescu, Sorin M.
Abstract

Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483-510] predicts that idiosyncratic risk should be priced when investors hold sub-optimally diversified portfolios, and cross-sectional stock returns should be positively related to their idiosyncratic risk. However, the literature generally finds a negative relationship between returns and idiosyncratic risk, which is more consistent with Miller's [1977. Risk, uncertainty, and divergence of opinion. Journal of Finance 32, 1151-1168] analysis of asset pricing under short-sale constraints. We examine the cross-sectional effects of idiosyncratic risk while explicitly recognizing the confounding effects that dispersion of beliefs and short-sale constraints produce in the Merton framework. We find strong support for Merton's [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483-510] model among stocks that have low levels of investor recognition and for which short selling is limited. For these stocks, the relation between idiosyncratic risk and expected returns is positive, as predicted by Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483-510].

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Publisher Info
Article provided by Elsevier in its journal Journal of Financial Markets.

Volume (Year): 12 (2009)
Issue (Month): 3 (August)
Pages: 438-468
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Handle: RePEc:eee:finmar:v:12:y:2009:i:3:p:438-468

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Web page: http://www.elsevier.com/locate/finmar

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Related research
Keywords: Market efficiency Idiosyncratic risk Short sales;

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This page was last updated on 2009-12-3.

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