Effect of Price Inefficiency on Idiosyncratic Risk and Stock Returns
54 Pages Posted: 3 Sep 2013 Last revised: 28 Dec 2013
Date Written: November 27, 2013
This paper finds that price inefficiency in individual stocks contributes to expected idiosyncratic volatility. If idiosyncratic risk is priced, greater price inefficiency could be associated with higher expected returns. Consistent with this hypothesis, this paper then finds a positive relation between price inefficiency and future stock returns. This return premium of price inefficiency is not explained by traditional risk factors, illiquidity, or transactions costs. It is also evidently different from the return bias related to Jensen’s inequality. This paper thus provides new insights about the determinants of expected stock returns, and new supporting evidence that idiosyncratic risk is priced.
Keywords: mispricing, idiosyncratic risk, stock return
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation