A New Value-to-Price Anomaly and the Idiosyncratic Risk

52 Pages Posted: 1 Nov 2009 Last revised: 27 Jan 2011

See all articles by Lee-Seok Hwang

Lee-Seok Hwang

Seoul National University - College of Business Administration

Byungcherl Charlie Sohn

University of Macau - Department of Accounting and Information Management

Date Written: November 18, 2010

Abstract

This study documents the prominent role of idiosyncratic risk in impeding arbitrage activities with regard to a new value-to-price anomaly. Adopting the theoretical foundation and empirical specification of Hwang and Sohn’s (2010) real-option-based valuation model, we measure the intrinsic value of a firm’s equity (Vo) by explicitly incorporating the shareholders’ abandonment option into the residual-income-based value estimate. This new value-to-price (Vo/P) ratio has a unique return predictability after controlling for previously known return determinants (such as beta, the book-to-market ratio, and momentum), especially when the probability of exercising the shareholders’ abandonment option is high. We call the power of Vo/P to predict future returns the “Vo/P anomaly.” We find that this Vo/P anomaly is exacerbated by idiosyncratic risk to a greater extent than by any other arbitrage risk factor, including institutional ownership, analyst coverage, bid-ask spread, and trading volume. This evidence is consistent with an emerging stream of literature that claims that idiosyncratic risk is the single greatest impediment to market efficiency. We also find that the impact of idiosyncratic volatility on the Vo/P anomaly is more pronounced for firms with a high probability of exercising the abandonment option. Our findings are robust to various sensitivity tests.

Keywords: abandonment option, value-to-price anomaly, idiosyncratic risk, arbitrage

JEL Classification: G12, G14, M41

Suggested Citation

Hwang, Lee-Seok and Sohn, Byungcherl Charlie, A New Value-to-Price Anomaly and the Idiosyncratic Risk (November 18, 2010). Available at SSRN: https://ssrn.com/abstract=1497974 or http://dx.doi.org/10.2139/ssrn.1497974

Lee-Seok Hwang

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

Byungcherl Charlie Sohn (Contact Author)

University of Macau - Department of Accounting and Information Management ( email )

Ave. Padre Tomas Pereira
Taipa
Macau
China

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