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Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

58 Pages Posted: 2 Oct 2012 Last revised: 13 Sep 2015

Robert F. Stambaugh

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

Jianfeng Yu

Tsinghua University - PBC School of Finance

Yu Yuan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); University of Pennsylvania - Wharton Financial Institutions Center

Multiple version iconThere are 2 versions of this paper

Date Written: October 12, 2014

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.

Keywords: arbitrage risk, idiosyncratic volatility puzzle, short-sale constraints, investor sentiment

Suggested Citation

Stambaugh, Robert F. and Yu, Jianfeng and Yuan, Yu, Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle (October 12, 2014). Journal of Finance, Vol 70, pp 1903-1948, 2015. Available at SSRN: https://ssrn.com/abstract=2155491 or http://dx.doi.org/10.2139/ssrn.2155491

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

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

Yu Yuan (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

University of Pennsylvania - Wharton Financial Institutions Center

3733 Spruce Street
Philadelphia, PA 19104-6374
United States

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