Cross-sectional dispersion and expected returns

Abstract

This study investigates whether the cross-sectional dispersion of stock returns, which reflects the aggregate level of idiosyncratic risk in the market, represents a priced state variable. We find that stocks with high sensitivities to dispersion offer low expected returns. Furthermore, a zero-cost spread portfolio that is long (short) in stocks with low (high) dispersion betas produces a statistically and economically significant return. Dispersion is associated with a significantly negative risk premium in the cross section (–1.32% per annum) which is distinct from premia commanded by alternative systematic factors. These results are robust to stock characteristics and market conditions.

Keywords:

• Cross-sectional dispersion
• Cross section of stock returns
• Pricing factor

JEL Classification:

• G11
• G12

Notes

¹ Another stream of the literature has used the cross-sectional dispersion of asset returns as a measure of investors’ herding. A substantial number of papers have focused on the cross-sectional dispersion to examine herding effects in the stock market (Chiang and Zheng 2010; Galariotis et al. 2015), the options market (Bernales et al., forthcoming), and the market for corporate bonds (Cai et al. 2012).

² Please refer to Maio (2016) for a much more detailed discussion of the two-factor asset pricing model.

³ We follow Pastor and Stambaugh (2003) and measure the liquidity of a given stock i as the coefficient γ_i,t from the following regression.