Pricing Implications of Noise
62 Pages Posted: 8 Jul 2021 Last revised: 20 May 2022
Date Written: October 30, 2021
We study the interaction of noisy demand and skewed asset payoffs. In our model, price as a function of quantities is convex in a neighborhood around zero if and only if skewness is positive. The combination of convexity and noise produces the idiosyncratic skewness effect--a documented negative relationship between an asset's idiosyncratic skewness and its expected return. We further offer an explanation for the idiosyncratic volatility puzzle. Finally, our theory predicts that higher idiosyncratic skewness strengthens the idiosyncratic volatility effect (and vice versa). We find support for this prediction in the cross section of stock returns.
Keywords: the skewness effect; the volatility effect; noise
JEL Classification: G12, D53, D82
Suggested Citation: Suggested Citation