Is Aggregate Idiosyncratic Risk Priced? Follow the Bid-Ask Bounce

61 Pages Posted: 17 Aug 2014 Last revised: 30 Oct 2015

See all articles by David A. Lesmond

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Yihua Zhao

Tulane University - A.B. Freeman School of Business

Date Written: October 21, 2015

Abstract

This paper models a market microstructure bias, driven by the bid-ask spread, that is evident in the pricing of aggregate firm-level risk embodied by the stock return variance estimates of Goyal and Santa-Clara (2003). Controlling for this bias, we find no pricing ability for aggregate firm-level variance for the period 1927 to 2012 or for any sub-period tested. Market microstructure also explains the time-trend of aggregate firm-level volatility observed from 1962 to 1997 (Campbell, Lettau, Malkiel, and Xu, 2001), and subsumes any relation between retail trading and future idiosyncratic volatility from 1983 to 1999 (Brandt, Brav, Graham, and Kumar, 2010). We conclude that the aggregate firm-level bid-ask spread is priced with future market returns rather than any of the aggregate firm-level risk measures.

Keywords: Asset Pricing, Market Returns, Aggregate Firm-Level Volatility, Risk, Bid-Ask Spread, Percentage of Zero Returns

JEL Classification: J10, H10

Suggested Citation

Lesmond, David A. and Zhao, Yihua, Is Aggregate Idiosyncratic Risk Priced? Follow the Bid-Ask Bounce (October 21, 2015). Finance Down Under 2015 Building on the Best from the Cellars of Finance Paper. Available at SSRN: https://ssrn.com/abstract=2481142 or http://dx.doi.org/10.2139/ssrn.2481142

David A. Lesmond (Contact Author)

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
511 Goldring-Woldenberg Hall
New Orleans, LA 70118
United States
504-865-5665 (Phone)
504-865-6751 (Fax)

Yihua Zhao

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
New Orleans, LA 70118
United States

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