Harrison G. Hong
Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
David Alexandre Sraer
University of California, Berkeley; Princeton University
May 27, 2015
The risk and return trade-off, the cornerstone of modern asset pricing theory, is often of the wrong sign. Our explanation is that high beta assets are more prone to speculative overpricing than low beta ones. When investors disagree about the prospects of the stock market, high beta assets are more sensitive to this aggregate disagreement and experience a greater divergence of opinion about their payoffs. If their dividends’ variance is low enough, these assets experience speculative demand from optimistic investors. Short-sales constraints then result in these high beta assets being over-priced. When aggregate disagreement is low, the Security Market Line is upward sloping due to risk-sharing. When aggregate disagreement is high, expected returns can actually decrease with beta, especially for stocks with low idiosyncratic variance. We confirm our theory using a measure of disagreement about stock market earnings.
Number of Pages in PDF File: 79
Date posted: December 3, 2011 ; Last revised: July 28, 2015
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