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Forecast Dispersion and the Cross Section of Expected Returns

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  • TIMOTHY C. JOHNSON

Abstract

Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' earnings forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when asset values are unobservable. The relationship then follows from a general options-pricing result: For a levered firm, expected returns should always decrease with the level of idiosyncratic asset risk. This story is formalized with a straightforward model. Reasonable parameter values produce large effects, and the theory's main empirical prediction is supported in cross-sectional tests. Copyright 2004 by The American Finance Association.

Suggested Citation

  • Timothy C. Johnson, 2004. "Forecast Dispersion and the Cross Section of Expected Returns," Journal of Finance, American Finance Association, vol. 59(5), pages 1957-1978, October.
  • Handle: RePEc:bla:jfinan:v:59:y:2004:i:5:p:1957-1978
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