Pricing Implications of Noise

Review of Financial Studies, forthcoming

62 Pages Posted: 8 Jul 2021 Last revised: 23 May 2022

See all articles by Christian L. Goulding

Christian L. Goulding

Auburn University - Harbert College of Business

Shrihari Santosh

University of Colorado at Boulder - Department of Finance; University of Maryland - R.H. Smith School of Business

Xingtan Zhang

University of Colorado at Boulder - Department of Finance

Date Written: October 30, 2021

Abstract

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

Goulding, Christian L. and Santosh, Shrihari and Zhang, Xingtan, Pricing Implications of Noise (October 30, 2021). Review of Financial Studies, forthcoming, Available at SSRN: https://ssrn.com/abstract=3875824 or http://dx.doi.org/10.2139/ssrn.3875824

Christian L. Goulding

Auburn University - Harbert College of Business ( email )

Auburn, AL 36849
United States

Shrihari Santosh

University of Colorado at Boulder - Department of Finance ( email )

Campus Box 419
Boulder, CO 80309
United States

University of Maryland - R.H. Smith School of Business ( email )

Robert H. Smith School of Business
Van Munching Hall
College Park, MD 20742
United States

Xingtan Zhang (Contact Author)

University of Colorado at Boulder - Department of Finance ( email )

Campus Box 419
Boulder, CO 80309
United States

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