IDEAS home Printed from https://ideas.repec.org/a/eee/finmar/v12y2009i3p438-468.html
   My bibliography  Save this article

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

Author

Listed:
  • 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
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S1386-4181(09)00014-7
    Download Restriction: Full text for ScienceDirect subscribers only
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Mitchell, Mark L & Stafford, Erik, 2000. "Managerial Decisions and Long-Term Stock Price Performance," The Journal of Business, University of Chicago Press, vol. 73(3), pages 287-329, July.
    2. Karl B. Diether & Christopher J. Malloy & Anna Scherbina, 2002. "Differences of Opinion and the Cross Section of Stock Returns," Journal of Finance, American Finance Association, vol. 57(5), pages 2113-2141, October.
    3. Pamela Parrish Peterson & David R. Peterson, 1982. "Divergence Of Opinion And Return," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 5(2), pages 125-134, June.
    4. Mayers, David, 1976. "Nonmarketable Assets, Market Segmentation, and the Level of Asset Prices," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 11(1), pages 1-12, March.
    5. Stephen Morris, 1996. "Speculative Investor Behavior and Learning," The Quarterly Journal of Economics, Oxford University Press, vol. 111(4), pages 1111-1133.
    6. H. Kent Baker & Gary E. Powell & Daniel G. Weaver, 1999. "Does NYSE Listing Affect Firm Visibility?," Financial Management, Financial Management Association, vol. 28(2), Summer.
    7. Chen, Joseph & Hong, Harrison & Stein, Jeremy C., 2002. "Breadth of ownership and stock returns," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 171-205.
    8. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    9. Hemang Desai & K. Ramesh & S. Ramu Thiagarajan & Bala V. Balachandran, 2002. "An Investigation of the Informational Role of Short Interest in the Nasdaq Market," Journal of Finance, American Finance Association, vol. 57(5), pages 2263-2287, October.
    10. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
    11. Jarrow, Robert A, 1980. "Heterogeneous Expectations, Restrictions on Short Sales, and Equilibrium Asset Prices," Journal of Finance, American Finance Association, vol. 35(5), pages 1105-1113, December.
    12. David L. Ikenberry & Sundaresh Ramnath, 2002. "Underreaction to Self-Selected News Events: The Case of Stock Splits," Review of Financial Studies, Society for Financial Studies, vol. 15(2), pages 489-526, March.
    13. Alexander Shapiro, 2002. "The Investor Recognition Hypothesis in a Dynamic General Equilibrium: Theory and Evidence," Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 97-141, March.
    14. William R. Gebhardt & Charles M. C. Lee & Bhaskaran Swaminathan, 2001. "Toward an Implied Cost of Capital," Journal of Accounting Research, Wiley Blackwell, vol. 39(1), pages 135-176, June.
    15. Merton, Robert C, 1987. "A Simple Model of Capital Market Equilibrium with Incomplete Information," Journal of Finance, American Finance Association, vol. 42(3), pages 483-510, July.
    16. Miller, Edward M, 1977. "Risk, Uncertainty, and Divergence of Opinion," Journal of Finance, American Finance Association, vol. 32(4), pages 1151-1168, September.
    17. Eckbo, B. Espen & Norli, Oyvind, 2005. "Liquidity risk, leverage and long-run IPO returns," Journal of Corporate Finance, Elsevier, vol. 11(1-2), pages 1-35, March.
    18. Figlewski, Stephen, 1981. "The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(4), pages 463-476, November.
    19. Duffie, Darrell & Garleanu, Nicolae & Pedersen, Lasse Heje, 2002. "Securities lending, shorting, and pricing," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 307-339.
    20. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
    21. Falkenstein, Eric G, 1996. "Preferences for Stock Characteristics as Revealed by Mutual Fund Portfolio Holdings," Journal of Finance, American Finance Association, vol. 51(1), pages 111-135, March.
    22. Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2006. "The Cross‐Section of Volatility and Expected Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 259-299, February.
    23. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    24. Asquith, Paul & Pathak, Parag A. & Ritter, Jay R., 2005. "Short interest, institutional ownership, and stock returns," Journal of Financial Economics, Elsevier, vol. 78(2), pages 243-276, November.
    25. Danielsen, Bartley R. & Sorescu, Sorin M., 2001. "Why Do Option Introductions Depress Stock Prices? A Study of Diminishing Short Sale Constraints," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 36(4), pages 451-484, December.
    26. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 33(1), pages 125-132.
    27. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, August.
    28. Aggarwal, Reena & Klapper, Leora & Wysocki, Peter D., 2005. "Portfolio preferences of foreign institutional investors," Journal of Banking & Finance, Elsevier, vol. 29(12), pages 2919-2946, December.
    29. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-636, May-June.
    30. Diamond, Douglas W. & Verrecchia, Robert E., 1987. "Constraints on short-selling and asset price adjustment to private information," Journal of Financial Economics, Elsevier, vol. 18(2), pages 277-311, June.
    31. Rodney D. Boehme & Sorin M. Sorescu, 2002. "The Long‐run Performance Following Dividend Initiations and Resumptions: Underreaction or Product of Chance?," Journal of Finance, American Finance Association, vol. 57(2), pages 871-900, April.
    32. Loughran, Tim & Ritter, Jay R., 2000. "Uniformly least powerful tests of market efficiency," Journal of Financial Economics, Elsevier, vol. 55(3), pages 361-389, March.
    33. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-658, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Jorida Papakroni, 2018. "The dispersion anomaly and analyst recommendations," Review of Quantitative Finance and Accounting, Springer, vol. 50(3), pages 861-896, April.
    2. Amit Goyal, 2012. "Empirical cross-sectional asset pricing: a survey," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 26(1), pages 3-38, March.
    3. Guo, Hui & Qiu, Buhui, 2014. "Options-implied variance and future stock returns," Journal of Banking & Finance, Elsevier, vol. 44(C), pages 93-113.
    4. Kelley Bergsma & Jitendra Tayal, 2019. "Short Interest and Lottery Stocks," Financial Management, Financial Management Association International, vol. 48(1), pages 187-227, March.
    5. Adam Zaremba & Jacob Koby Shemer, 2018. "Price-Based Investment Strategies," Springer Books, Springer, number 978-3-319-91530-2, November.
    6. Boehme, Rodney & Çolak, Gönül, 2012. "Primary market characteristics and secondary market frictions of stocks," Journal of Financial Markets, Elsevier, vol. 15(2), pages 286-327.
    7. Au, Andrea S. & Doukas, John A. & Onayev, Zhan, 2009. "Daily short interest, idiosyncratic risk, and stock returns," Journal of Financial Markets, Elsevier, vol. 12(2), pages 290-316, May.
    8. Jank, Stephan & Roling, Christoph & Smajlbegovic, Esad, 2021. "Flying under the radar: The effects of short-sale disclosure rules on investor behavior and stock prices," Journal of Financial Economics, Elsevier, vol. 139(1), pages 209-233.
    9. Qian, Xiaolin, 2014. "Small investor sentiment, differences of opinion and stock overvaluation," Journal of Financial Markets, Elsevier, vol. 19(C), pages 219-246.
    10. Vidal-García, Javier & Vidal, Marta, 2014. "Seasonality and idiosyncratic risk in mutual fund performance," European Journal of Operational Research, Elsevier, vol. 233(3), pages 613-624.
    11. Barinov, Alexander & Wu, Juan (Julie), 2014. "High short interest effect and aggregate volatility risk," Journal of Financial Markets, Elsevier, vol. 21(C), pages 98-122.
    12. Andreou, Panayiotis C. & Kagkadis, Anastasios & Philip, Dennis & Tuneshev, Ruslan, 2018. "Differences in options investors’ expectations and the cross-section of stock returns," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 315-336.
    13. 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, vol. 28(C), pages 36-59.
    14. Lin, Zih-Ying & Chang, Chuang-Chang & Wang, Yaw-Huei, 2018. "The impacts of asymmetric information and short sales on the illiquidity risk premium in the stock option market," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 152-165.
    15. Min, Byoung-Kyu & Qiu, Buhui & Roh, Tai-Yong, 2022. "What drives the dispersion anomaly?," Journal of Banking & Finance, Elsevier, vol. 138(C).
    16. Wang, Huijun & Yan, Jinghua & Yu, Jianfeng, 2017. "Reference-dependent preferences and the risk–return trade-off," Journal of Financial Economics, Elsevier, vol. 123(2), pages 395-414.
    17. Wan, Xiaoyuan, 2018. "Is the idiosyncratic volatility anomaly driven by the MAX or MIN effect? Evidence from the Chinese stock market," International Review of Economics & Finance, Elsevier, vol. 53(C), pages 1-15.
    18. 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.
    19. Neszveda, G., 2019. "Essays on behavioral finance," Other publications TiSEM 05059039-5236-42a3-be1b-3, Tilburg University, School of Economics and Management.
    20. Jacobs, Heiko, 2015. "What explains the dynamics of 100 anomalies?," Journal of Banking & Finance, Elsevier, vol. 57(C), pages 65-85.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:finmar:v:12:y:2009:i:3:p:438-468. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/finmar .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.