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Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle


Robert F. Stambaugh


University of Pennsylvania - The Wharton School; National Bureau of Economic Research (NBER)

Jianfeng Yu


University of Minnesota

Yu Yuan


Shanghai Advanced Institute of Finance; University of Pennsylvania - Wharton Financial Institutions Center

October 12, 2014

Journal of Finance, Forthcoming

Abstract:     
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

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Date posted: October 2, 2012 ; Last revised: November 7, 2014

Suggested Citation

Stambaugh, Robert F. and Yu, Jianfeng and Yuan, Yu, Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle (October 12, 2014). Journal of Finance, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2155491 or http://dx.doi.org/10.2139/ssrn.2155491

Contact Information

Robert F. Stambaugh
University of Pennsylvania - The Wharton School ( email )
The Wharton School, Finance Department
University of Pennsylvania
Philadelphia, PA 19104-6367
United States
215-898-5734 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Jianfeng Yu
University of Minnesota ( email )
321 19th Avenue
Suite 3-122
Minneapolis, MN 55455
United States
HOME PAGE: http://users.cla.umn.edu/~jianfeng/
Yu Yuan (Contact Author)
Shanghai Advanced Institute of Finance ( email )
Shanghai
China
HOME PAGE: http://https://finance.wharton.upenn.edu/~yuanyu
University of Pennsylvania - Wharton Financial Institutions Center ( email )
3733 Spruce Street
Philadelphia, PA 19104-6374
United States
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