Covariance Risk, Mispricing, and the Cross Section of Security Returns

47 Pages Posted: 16 May 2000 Last revised: 1 Apr 2001

See all articles by Kent D. Daniel

Kent D. Daniel

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business; NBER

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2000

Abstract

This paper offers a multisecurity model in which prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade to profit from mispricing. We derive a pricing relationship in which expected returns are linearly related to both risk and mispricing variables. The model thereby implies a multivariate relation between expected return, beta, and variables that proxy for mispricing of idiosyncratic components of value tends to be arbitraged away but systematic mispricing is not. The theory is consistent with several empirical findings regarding the cross-section of equity returns, including: the observed ability of fundamental/price ratios to forecast aggregate and cross-sectional returns, and of market value but not non-market size measures to forecast returns cross-sectionally; and the ability in some studies of fundamental/price ratios and market value to dominate traditional measures of security risk. The model also offers several untested empirical implications for the cross-section of expected returns and for the relation of volume to subsequent volatility.

Suggested Citation

Daniel, Kent D. and Hirshleifer, David A. and Subrahmanyam, Avanidhar, Covariance Risk, Mispricing, and the Cross Section of Security Returns (March 2000). NBER Working Paper No. w7615. Available at SSRN: https://ssrn.com/abstract=228092

Kent D. Daniel (Contact Author)

Columbia Business School - Finance and Economics ( email )

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HOME PAGE: http://kentdaniel.net/

National Bureau of Economic Research (NBER)

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David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA California 92697-3125
United States

HOME PAGE: http://sites.uci.edu/dhirshle/

NBER ( email )

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Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Institute of Global Finance, UNSW Business School

Sydney, NSW 2052
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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