Idiosyncratic Risk, Investor Base and Returns

42 Pages Posted: 15 May 2014

See all articles by Doina Chichernea

Doina Chichernea

University of Denver - Reiman School of Finance

Michael F. Ferguson

University of Cincinnati - Department of Finance - Real Estate

Haim Kassa

Miami University

Date Written: May 1, 2014

Abstract

We provide empirical evidence for the incomplete information model advanced by Merton (1987), which shows that the relation between idiosyncratic volatility (IV) and expected return is conditional on the firm’s investor base. Using four different proxies for investor base, we show that idiosyncratic risk premiums are larger for neglected stocks, and smaller or even economically insignificant for visible stocks. Since neglected stocks have greater IV, the total IV risk premium (price times quantity) for neglected stocks will be greater than for visible stocks. Additionally, we find a positive size effect and negative beta effect after controlling for IV, which are both consistent with Merton’s model predictions. Overall, our results provide strong support for the theory that the market segmentation induced by incomplete information is an important component of the documented influence of IV in the cross-section of returns.

Keywords: Idiosyncratic Volatility, Investor Base, cross section of stock returns

JEL Classification: G12, G14

Suggested Citation

Chichernea, Doina and Ferguson, Michael F. and Kassa, Haim, Idiosyncratic Risk, Investor Base and Returns (May 1, 2014). Available at SSRN: https://ssrn.com/abstract=2436609 or http://dx.doi.org/10.2139/ssrn.2436609

Doina Chichernea (Contact Author)

University of Denver - Reiman School of Finance ( email )

2101 S. University Blvd
Denver, CO 80208
United States

Michael F. Ferguson

University of Cincinnati - Department of Finance - Real Estate ( email )

College of Business Administration
Cincinnati, OH 45221
United States
513-556-7080 (Phone)

Haim Kassa

Miami University ( email )

800 E. Main St
The Farmer School of Business
Oxford, OH 45056
United States
(513) 529-2057 (Phone)
(513) 556-4891 (Fax)

HOME PAGE: http://fsb.miamioh.edu/kassah

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