Idiosyncratic Risk and the Cross-Section of Stock Returns: Merton (1987) Meets Miller (1977)

43 Pages Posted: 18 Mar 2005

See all articles by Rodney D Boehme

Rodney D Boehme

Wichita State University - Department of Finance, Real Estate & Decision Sciences (FREDS)

Praveen Kumar

University of Houston - Department of Finance

Bartley R. Danielsen

North Carolina State University - Poole College of Management

Sorin M. Sorescu

Texas A&M University - Department of Finance

Date Written: March 15, 2005

Abstract

Merton (1987) predicts that idiosyncratic risk should be priced when investors hold sub-optimally diversified portfolios, but empirical research has not been supportive of the theory. An overlooked assumption in Merton (1987) is that the predictions are predicated on frictionless markets, and in particular an absence of short-sale constraints. We examine the cross-sectional effects of idiosyncratic risk (and dispersion of beliefs) while controlling for short-sale constraints. We find that when short-sale constraints are absent, both idiosyncratic risk and dispersion of analyst forecasts are positively correlated with future abnormal returns; a result consistent with Merton (1987). However, when short-sale constraints are present the correlation becomes negative: increased analyst dispersion and idiosyncratic volatility produce negative abnormal returns, consistent with Miller (1977). This can explain the inconsistent empirical findings in the previous literature, which casts Merton (1987) and Miller (1977) as competing hypotheses.

Keywords: Idiosyncratic volatility, expected returns

JEL Classification: G12

Suggested Citation

Boehme, Rodney D and Kumar, Praveen and Danielsen, Bartley R. and Sorescu, Sorin M., Idiosyncratic Risk and the Cross-Section of Stock Returns: Merton (1987) Meets Miller (1977) (March 15, 2005). Available at SSRN: https://ssrn.com/abstract=685703 or http://dx.doi.org/10.2139/ssrn.685703

Rodney D Boehme

Wichita State University - Department of Finance, Real Estate & Decision Sciences (FREDS) ( email )

Wichita, KS 67260-0078
United States

Praveen Kumar

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States
713-743-4770 (Phone)
713-743-4789 (Fax)

Bartley R. Danielsen

North Carolina State University - Poole College of Management ( email )

Hillsborough Street
Raleigh, NC 27695-8614
United States
919-513-3003 (Phone)

Sorin M. Sorescu (Contact Author)

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

430 Wehner
College Station, TX 77843-4218
United States
979-458-0380 (Phone)

HOME PAGE: http://wehner.tamu.edu/finc.www/ssorescu/

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