Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle
Robert F. Stambaugh
University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)
University of Minnesota
Shanghai Advanced Institute of Finance; University of Pennsylvania - Wharton Financial Institutions Center
October 12, 2014
Journal of Finance, Forthcoming
Many investors purchase stock but are reluctant or unable to sell short. 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.
Number of Pages in PDF File: 58
Keywords: arbitrage risk, idiosyncratic volatility puzzle, short-sale constraints, investor sentiment
Date posted: October 2, 2012 ; Last revised: November 7, 2014
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