Disagreement, Skewness, and Asset Prices

Abstract

We develop a new asset pricing theory that bridges two seemingly unrelated anomalies: (1) the negative relationship between dispersion in financial analysts’ earnings forecasts and expected returns and (2) the negative relationship between ex-ante skewness and expected returns. The results obtain because (1) empirically, most stocks have positive expected ex-ante skewness, (2) positive skewness implies that investors' demand schedules are convex in the relevant price range, and (3) because of convexity, trades due to disagreement do not ``cancel out", and asset prices are inflated, even in a setup without short-selling constraints. Our theory further predicts that skewness and dispersion have an interactive pricing impact. We find support for this prediction in the cross section of stock returns.

Keywords: the dispersion effect; the skewness effect; divergence of opinions

JEL Classification: G12, D53, D82