Return Dispersion and the Cross-Section of Stock Returns

86 Pages Posted: 29 Jun 2018 Last revised: 23 Jun 2019

See all articles by Wei Liu

Wei Liu

Texas A&M University - Department of Finance

James W. Kolari

Texas A&M University - Department of Finance

Jianhua Huang

Texas A&M University - Department of Statistics

Date Written: June 19, 2019

Abstract

This paper shows that return dispersion (RD) is a significant market risk factor that helps to explain the cross-section of stock returns. We propose that stocks can have positive and negative sensitivity to RD movements over time. To capture asymmetric RD effects, we augment the CAPM market factor with RD in a novel two-component probabilistic mixture model. Each component of the mixture model is a two-factor regression model that captures both the market effect and the RD effect with a specific sign (positive or negative). We employ an expectation-maximization (EM) algorithm to estimate the parameters of the mixture model. Our so-called ZCAPM takes into account beta risk associated with the market factor and zeta risk related to the return dispersion factor. Out-of-sample cross-sectional tests of U.S. stock portfolios in the period 1965 to 2015 yield highly significant estimates for the market price of zeta risk. Our results for zeta risk dominate those for popular multi-factors, which are less significant than RD across different test assets and sample periods. Moreover, estimates of the market premium for zeta risk are economically substantial. These and other empirical tests suggest that zeta risk associated with return dispersion in our ZCAPM is a salient asset pricing factor.

Keywords: Asset Pricing, Cross-sectional Stock Returns, EM Regression, Return Dispersion

JEL Classification: G12, C20

Suggested Citation

Liu, Wei and Kolari, James W. and Huang, Jianhua, Return Dispersion and the Cross-Section of Stock Returns (June 19, 2019). Available at SSRN: https://ssrn.com/abstract=3200095 or http://dx.doi.org/10.2139/ssrn.3200095

Wei Liu

Texas A&M University - Department of Finance ( email )

430 Wehner
College Station, TX 77843-4218
United States

James W. Kolari (Contact Author)

Texas A&M University - Department of Finance ( email )

MS-4218
Department of Finance
College Station, TX TX 77843-4218
United States
979-845-4803 (Phone)
979-845-3884 (Fax)

Jianhua Huang

Texas A&M University - Department of Statistics ( email )

155 Ireland Street
447 Blocker
College Station, TX 77843
United States

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