Pricing Implications of Noise

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