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

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  • 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].

Suggested Citation

  • Boehme, Rodney D. & Danielsen, Bartley R. & Kumar, Praveen & Sorescu, Sorin M., 2009. "Idiosyncratic risk and the cross-section of stock returns: Merton (1987) meets Miller (1977)," Journal of Financial Markets, Elsevier, vol. 12(3), pages 438-468, August.
  • Handle: RePEc:eee:finmar:v:12:y:2009:i:3:p:438-468
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    Cited by:

    1. Wang, Huijun & Yan, Jinghua & Yu, Jianfeng, 2017. "Reference-dependent preferences and the risk–return trade-off," Journal of Financial Economics, Elsevier, pages 395-414.
    2. Trinks, Arjan & Scholtens, Bert & Mulder, Machiel & Dam, Lammertjan, 2017. "Divesting Fossil Fuels: The Implications for Investment Portfolios," MPRA Paper 76383, University Library of Munich, Germany.
    3. Miralles-Marcelo, José Luis & Miralles-Quirós, María del Mar & Miralles-Quirós, José Luis, 2012. "Asset pricing with idiosyncratic risk: The Spanish case," International Review of Economics & Finance, Elsevier, pages 261-271.
    4. Jiang, Danling & Peterson, David R. & Doran, James S., 2014. "Short-sale constraints and the idiosyncratic volatility puzzle: An event study approach," Journal of Empirical Finance, Elsevier, pages 36-59.
    5. Abad, Pilar & Robles, M. Dolores, 2014. "Credit rating agencies and idiosyncratic risk: Is there a linkage? Evidence from the Spanish Market," International Review of Economics & Finance, Elsevier, pages 152-171.
    6. Schneider, Paul & Wagner, Christian & Zechner, Josef, 2016. "Low risk anomalies?," CFS Working Paper Series 550, Center for Financial Studies (CFS).
    7. Jacobs, Heiko & Weber, Martin, 2015. "On the determinants of pairs trading profitability," Journal of Financial Markets, Elsevier, pages 75-97.
    8. Yung, Kenneth & Nafar, Nadia, 2017. "Investor attention and the expected returns of reits," International Review of Economics & Finance, Elsevier, pages 423-439.
    9. Boehme, Rodney & Çolak, Gönül, 2012. "Primary market characteristics and secondary market frictions of stocks," Journal of Financial Markets, Elsevier, pages 286-327.
    10. Hou, Kewei & Loh, Roger K., 2016. "Have we solved the idiosyncratic volatility puzzle?," Journal of Financial Economics, Elsevier, pages 167-194.
    11. Carlin, Bruce I. & Longstaff, Francis A. & Matoba, Kyle, 2014. "Disagreement and asset prices," Journal of Financial Economics, Elsevier, pages 226-238.
    12. repec:eee:quaeco:v:65:y:2017:i:c:p:182-193 is not listed on IDEAS
    13. Dinh, Minh Thi Hong, 2017. "The returns, risk and liquidity relationship in high frequency trading: Evidence from the Oslo stock market," Research in International Business and Finance, Elsevier, pages 30-40.
    14. Huang, Peng & Officer, Micah S. & Powell, Ronan, 2016. "Method of payment and risk mitigation in cross-border mergers and acquisitions," Journal of Corporate Finance, Elsevier, pages 216-234.
    15. Jeffrey Hobbs & Hei Wai Lee & Vivek Singh, 2017. "New evidence on the effect of belief heterogeneity on stock returns," Review of Quantitative Finance and Accounting, Springer, pages 289-309.
    16. Pithak Srisuksai, 2012. "Idiosyncratic Volatility and Expected Stock Returns: Evidence from Thailand," Applied Economics Journal, Kasetsart University, Faculty of Economics, Center for Applied Economic Research, vol. 19(2), pages 66-89, December.
    17. Barinov, Alexander & Wu, Juan (Julie), 2014. "High short interest effect and aggregate volatility risk," Journal of Financial Markets, Elsevier, pages 98-122.
    18. repec:eee:reveco:v:53:y:2018:i:c:p:1-15 is not listed on IDEAS
    19. Malagon, Juliana & Moreno, David & Rodríguez, Rosa, 2015. "The idiosyncratic volatility anomaly: Corporate investment or investor mispricing?," Journal of Banking & Finance, Elsevier, vol. 60(C), pages 224-238.
    20. Nartea, Gilbert V. & Wu, Ji, 2013. "Is there a volatility effect in the Hong Kong stock market?," Pacific-Basin Finance Journal, Elsevier, pages 119-135.
    21. Trinks, Arjan & Scholtens, Bert & Mulder, Machiel & Dam, Lammertjan, 2017. "Divesting Fossil Fuels," Research Report 17001-EEF, University of Groningen, Research Institute SOM (Systems, Organisations and Management).
    22. Aboulamer, Anas & Kryzanowski, Lawrence, 2016. "Are idiosyncratic volatility and MAX priced in the Canadian market?," Journal of Empirical Finance, Elsevier, pages 20-36.

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