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Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

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  • ROBERT F. STAMBAUGH
  • JIANFENG YU
  • YU YUAN

Abstract

type="main"> Buying is easier than shorting for many equity investors. Combining this arbitrage asymmetry with the arbitrage risk represented by idiosyncratic volatility (IVOL) explains the negative relation between IVOL and average return. The IVOL-return relation is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. Consistent with arbitrage asymmetry, the negative relation among overpriced stocks is stronger, especially for stocks less easily shorted, so the overall IVOL-return relation is negative. Further supporting our explanation, high investor sentiment weakens the positive relation among underpriced stocks and, especially, strengthens the negative relation among overpriced stocks.

Suggested Citation

  • Robert F. Stambaugh & Jianfeng Yu & Yu Yuan, 2015. "Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle," Journal of Finance, American Finance Association, vol. 70(5), pages 1903-1948, October.
  • Handle: RePEc:bla:jfinan:v:70:y:2015:i:5:p:1903-1948
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    File URL: http://hdl.handle.net/10.1111/jofi.12286
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    Cited by:

    1. Stambaugh, Robert F. & Yu, Jianfeng & Yuan, Yu, 2014. "The long of it: Odds that investor sentiment spuriously predicts anomaly returns," Journal of Financial Economics, Elsevier, vol. 114(3), pages 613-619.
    2. Wang, Huijun & Yan, Jinghua & Yu, Jianfeng, 2017. "Reference-dependent preferences and the riskÔÇôreturn trade-off," Journal of Financial Economics, Elsevier, vol. 123(2), pages 395-414.
    3. repec:eee:pacfin:v:46:y:2017:i:pa:p:141-157 is not listed on IDEAS
    4. repec:kap:rqfnac:v:50:y:2018:i:1:d:10.1007_s11156-017-0628-y is not listed on IDEAS
    5. Yang, Chunpeng & Zhou, Liyun, 2016. "Individual stock crowded trades, individual stock investor sentiment and excess returns," The North American Journal of Economics and Finance, Elsevier, vol. 38(C), pages 39-53.
    6. Azi Ben-Rephael & Bruce I. Carlin & Zhi Da & Ryan D. Israelsen, 2017. "Demand for Information and Asset Pricing," NBER Working Papers 23274, National Bureau of Economic Research, Inc.
    7. repec:eee:ecofin:v:42:y:2017:i:c:p:504-512 is not listed on IDEAS
    8. Lubos Pastor & Robert F. Stambaugh & Lucian A. Taylor, 2017. "Fund Tradeoffs," NBER Working Papers 23670, National Bureau of Economic Research, Inc.
    9. repec:eee:reveco:v:53:y:2018:i:c:p:1-15 is not listed on IDEAS
    10. Liu, Qi & Lu, Lei & Sun, Bo & Yan, Hongjun, 2015. "A Model of Anomaly Discovery," International Finance Discussion Papers 1128, Board of Governors of the Federal Reserve System (U.S.).
    11. repec:eee:reveco:v:53:y:2018:i:c:p:118-132 is not listed on IDEAS
    12. Shen, Junyan & Yu, Jianfeng & Zhao, Shen, 2017. "Investor sentiment and economic forces," Journal of Monetary Economics, Elsevier, vol. 86(C), pages 1-21.
    13. Tim Bollerslev & Sophia Zhengzi Li & Viktor Todorov, 2014. "Roughing up Beta: Continuous vs. Discontinuous Betas, and the Cross-Section of Expected Stock Returns," CREATES Research Papers 2014-48, Department of Economics and Business Economics, Aarhus University.
    14. Robert F. Stambaugh & Yu Yuan, 2015. "Mispricing Factors," NBER Working Papers 21533, National Bureau of Economic Research, Inc.
    15. repec:eee:jbfina:v:86:y:2018:i:c:p:240-258 is not listed on IDEAS
    16. Coqueret, Guillaume, 2017. "Empirical properties of a heterogeneous agent model in large dimensions," Journal of Economic Dynamics and Control, Elsevier, vol. 77(C), pages 180-201.
    17. Bucher, Melk C., 2017. "Investor Attention and Sentiment: Risk or Anomaly?," Working Papers on Finance 1712, University of St. Gallen, School of Finance.
    18. Haibin Xie & Shouyang Wang, 2015. "Risk-return trade-off, information diffusion, and U.S. stock market predictability," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(04), pages 1-20, December.
    19. Robert F. Stambaugh, 2014. "Investment Noise and Trends," NBER Working Papers 20072, National Bureau of Economic Research, Inc.
    20. Xiaomeng Lu & Robert F. Stambaugh & Yu Yuan, 2017. "Anomalies Abroad: Beyond Data Mining," NBER Working Papers 23809, National Bureau of Economic Research, Inc.
    21. Itamar Drechsler & Qingyi Freda Drechsler, 2014. "The Shorting Premium and Asset Pricing Anomalies," NBER Working Papers 20282, National Bureau of Economic Research, Inc.
    22. Cao, Jie & Han, Bing, 2016. "Idiosyncratic risk, costly arbitrage, and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 1-15.
    23. repec:eee:intfin:v:51:y:2017:i:c:p:1-14 is not listed on IDEAS

    More about this item

    JEL classification:

    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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