Daily short interest,idiosyncratic risk,and stock returns

This paper examines the relation between short selling and returns and the impact of arbitrage costs on short sellers’ behavior. Using daily UK short selling data, we find that stocks with low short interest levels experience significant positive returns on both an equal- and value-weighted basis. Economic theory predicts that short sellers avoid establishing positions in stocks with high idiosyncratic risk. Our results indicate a negative relation between short interest and returns among high idiosyncratic risk stocks and that short selling activity is mostly concentrated in low idiosyncratic risk stocks where it is less costly to arbitrage fundamental risk.     

Idiosyncratic risk,costly arbitrage,and the cross-section of stock returns

We test a new cross-sectional relation between expected stock return and idiosyncratic risk implied by the theory of costly arbitrage. If arbitrageurs find it more difficult to correct the mispricing of stocks with high idiosyncratic risk, there should be a positive (negative) relation between expected return and idiosyncratic risk for undervalued (overvalued) stocks. We combine several well-known anomalies to measure stock mispricing and proxy stock idiosyncratic risk using an exponential GARCH model for stock returns. We confirm that average stock returns monotonically increase (decrease) with idiosyncratic risk for undervalued (overvalued) stocks. Overall, our results support the importance of idiosyncratic risk as an arbitrage cost.     

Media tone and expected stock returns

We find that media tone reflects firm-level expected returns—firms with low-negative tone stories over a few months earn higher returns in the medium to long term than do firms with high-negative tone stories. The tone premium is driven by consistent outperformance of low-negative stocks, while high-negative stocks do not produce significant abnormal returns. The media tone effect is associated with some common risk factors, among which the size factor plays a consistent and most significant role. The tone effect also reflects differences in firms' idiosyncratic risk, and there is evidence that it is partially related to mispricing and limits to arbitrage.     

Costly arbitrage and idiosyncratic risk: Evidence from short sellers

Previous studies have shown that high short interest stocks have low subsequent returns. We test whether the persistence of this effect is due to costs limiting arbitrage. The arbitrage cost that we focus on is idiosyncratic risk which, regardless of the arbitrageur’s level of diversification, deters arbitrage activity. Consistent with costly arbitrage, we find that among high short interest stocks a one standard deviation increase in idiosyncratic risk predicts a more than 1% decline in monthly returns. Moreover, idiosyncratic risk does not predict returns across low short interest stocks, and short interest does not predict low returns across low idiosyncratic risk stocks. Our results are robust to commonly used proxies for both transaction costs and short sale constraints.     

Left-tail momentum: Underreaction to bad news,costly arbitrage and equity returns

This paper documents a significantly negative cross-sectional relation between left-tail risk and future returns on individual stocks trading in the US and international countries. We provide a behavioral explanation to this anomaly based on the idea that investors underestimate the persistence in left-tail risk and overprice stocks with large recent losses. Thus, low returns in the left-tail of the distribution persist into the future causing left-tail return momentum. We find that the left-tail risk anomaly is stronger for stocks that are more likely to be held by retail investors, that receive less investor attention, and that are costlier to arbitrage.     

Price Momentum and Idiosyncratic Volatility

We find that returns to momentum investing are higher among high idiosyncratic volatility ( IVol) stocks, especially high IVol losers. Higher IVol stocks also experience quicker and larger reversals. The findings are consistent with momentum profits being attributable to underreaction to firm‐specific information and with IVol limiting arbitrage of the momentum effect. We also find a positive time‐series relation between momentum returns and aggregate IVol. Given the long‐term rise in IVol, this result helps explain the persistence of momentum profits since Jegadeesh and Titman's (1993) study.     

Value at risk,mispricing and expected returns

This study investigates how the relation between value-at-risk (VaR) and expected returns differs under different mispricing statuses. We find that a significantly negative VaR-return relation, defined as the VaR effect, is observed only for overpriced stocks, but not for underpriced stocks. Moreover, VaR has an amplification effect on mispricing, indicating that VaR captures risk that deters arbitrage and thus leads to an increase in mispricing. Our results are robust to alternative VaR definitions, subperiod analysis, different market states, and after controlling for other firm characteristics, well-known risk factors, and those variables that have been shown to have amplifying effects on mispricing. Finally, this study also examines the pricing effect of short sale constraints on the VaR effect under different mispricing statuses. Our findings suggest that the VaR effect observed in overpriced stocks becomes more severe as short sales are more constrained.     

Idiosyncratic Volatility and Firm‐Specific News: Beyond Limited Arbitrage

We examine the relation between idiosyncratic volatility and returns around news announcements. Mispricing is most likely to occur during news announcements. If idiosyncratic volatility generates a limit to arbitrage, then the negative relation between returns and news volatility should be stronger than the relation to nonnews volatility. Instead, we find nonnews volatility has a robust negative relation to returns and lacks key features expected if volatility were a reflection of limits to arbitrage. Pricing of nonnews volatility is related to lottery‐like features of a stock's return. Our results suggest that volatility has a price effect beyond a limit to arbitrage.     

Taxes,dividend yields and returns in the UK equity market

The higher rate of taxation on dividend income relative to capital gains has been offered as an explanation for the positive relation between stock returns and dividend yields among US firms. In the UK the relative tax rates are the reverse of those in the US. Thus, UK data provides an independent test of the tax-based approach to explaining the relation between stock returns and dividend yields. We find that high yielding stocks earn positive risk adjusted returns, whereas low yielding stocks earn negative risk adjusted returns. We also detect evidence of non-linearity in the performance of zero-dividend stocks. Controlling for firm size, seasonality and market risk we find a significant positive relation between dividend yields and returns. We conclude that the evidence is inconsistent with a tax-based explanation.     

Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Buying is easier than shorting for many equity investors. Combining this arbitrage asymmetry with the arbitrage risk represented by idiosyncratic volatility (IVOL) explains the negative relation between IVOL and average return. The IVOL‐return relation is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. Consistent with arbitrage asymmetry, the negative relation among overpriced stocks is stronger, especially for stocks less easily shorted, so the overall IVOL‐return relation is negative. Further supporting our explanation, high investor sentiment weakens the positive relation among underpriced stocks and, especially, strengthens the negative relation among overpriced stocks.     

Are extreme returns priced in the stock market? European evidence

This paper revisits some recently found evidence in the literature on the cross-section of stock returns for a carefully constructed dataset of euro area stocks. First, we confirm recent results for US data and find evidence of a negative cross-sectional relation between extreme positive returns and average returns after controlling for characteristics such as momentum, book-to-market, size, liquidity and short term return reversal. We argue that this is the case because these stocks have lottery-like characteristics, which is attractive to certain investors. Also, these stocks tend to be very volatile so that arbitrageurs are discouraged from correcting potential mispricing. As a consequence, these stocks are often overpriced and hence face lower expected returns. Second, when we control for extreme returns, the recently found negative relationship between idiosyncratic risk and future returns is less robust. In our models, after adding maximum returns, the relationship is insignificant and sometimes even positive. We also find that idiosyncratic skewness and coskewness play an important role for asset pricing, as predicted by several theoretical models.     

The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies

We examine the causal effect of limits to arbitrage on 11 well-known asset pricing anomalies using the pilot program of Regulation SHO, which relaxed short-sale constraints for a quasi-random set of pilot stocks, as a natural experiment. We find that the anomalies became weaker on portfolios constructed with pilot stocks during the pilot period. The pilot program reduced the combined anomaly long–short portfolio returns by 72 basis points per month, a difference that survives risk adjustment with standard factor models. The effect comes only from the short legs of the anomaly portfolios.     

Death and jackpot: Why do individual investors hold overpriced stocks?

Campbell, Hilscher, and Szilagyi (2008) show that firms with a high probability of default have abnormally low average future returns. We show that firms with a high potential for default (death) also tend to have a relatively high probability of extremely large (jackpot) payoffs. Consistent with an investor preference for skewed, lottery-like payoffs, stocks with high predicted probabilities for jackpot returns earn abnormally low average returns. Stocks with high death or jackpot probabilities have relatively low institutional ownership and the jackpot effect we find is much stronger in stocks with high limits to arbitrage.     

Distress Anomaly and Shareholder Risk: International Evidence

Financially distressed stocks in the United States earn puzzlingly low returns giving rise to the distress risk anomaly. We provide evidence that the anomaly exists in developed countries, but not in emerging ones. Using cross‐country analyses, we explore several potential drivers of returns to distressed stocks. The distress anomaly is stronger in countries with stronger takeover legislation, lower barriers to arbitrage, and higher information transparency. In contrast, shareholder bargaining power and expected stock return skewness in a country do not affect the anomaly. These findings suggest that various aspects of shareholders’ risk play an important role in shaping distressed stocks returns.     

Firm efficiency and stock returns: Australian evidence

We employ a stochastic frontier approach to estimate firm efficiency - the efficiency with which a firm converts its inputs into output. We find a negative relation between firm efficiency and the cross-section of stock returns (‘firm efficiency effect’) in the Australian stock market. The firm efficiency effect is robust after controlling for other firm characteristics and is more pronounced in stocks with high limits-to-arbitrage. However, we find no evidence that firm efficiency is a priced factor in the cross-section. Our findings suggest that investors misprice firm efficiency and arbitrage costs perpetuate its return predictability.     

Ex Ante Skewness and Expected Stock Returns

We use option prices to estimate ex ante higher moments of the underlying individual securities’ risk‐neutral returns distribution. We find that individual securities’ risk‐neutral volatility, skewness, and kurtosis are strongly related to future returns. Specifically, we find a negative (positive) relation between ex ante volatility (kurtosis) and subsequent returns in the cross‐section, and more ex ante negatively (positively) skewed returns yield subsequent higher (lower) returns. We analyze the extent to which these returns relations represent compensation for risk and find evidence that, even after controlling for differences in co‐moments, individual securities’ skewness matters.     

SMALL FIRM AND VALUE EFFECTS IN THE CANADIAN STOCK MARKET

We examine the relation among average returns, market beta, firm size, and book-to-market value for Canadian stocks during 1975–92. We document a negative relation between average return and the market capitalization of firms, but find no relation between average return and market beta. While the small firm effect is significant during a period of reduced capital gains tax, it is noticeably lower than during the period leading up to the change. We find that average returns are positively related to book-to-market value especially during the period of lower capital gains tax.     

The asset growth effect: Insights from international equity markets

Firms with higher asset growth rates subsequently experience lower stock returns in international equity markets, consistent with the U.S. evidence. This negative effect of asset growth on returns is stronger in more developed capital markets and markets where stocks are more efficiently priced, but is unrelated to country characteristics representing limits to arbitrage, investor protection, and accounting quality. The evidence suggests that the cross-sectional relation between asset growth and stock return is more likely due to an optimal investment effect than due to overinvestment, market timing, or other forms of mispricing.     

Mispricing firm-level productivity

This paper provides a mispricing-based explanation for the negative relation between firm-level productivity and stock returns. Investors appear to underprice unproductive firms and overprice productive firms. We find evidence consistent with the speculative overpricing of productive firms driven by investor sentiment and short sale constraints. Investors erroneously extrapolate past productivity growth and its associated operating performance and stock returns, despite their subsequent reversals. Such mispricing is perpetuated because of limits to arbitrage and is partially corrected around earnings announcements when investors are surprised by unexpected earnings news. Decomposition analysis indicates that extrapolative mispricing and limits to arbitrage explain most of the return predictability of firm-level productivity.     

Short Interest and Lottery Stocks

We find short interest‐related mispricing is strongest in lottery stocks. As stocks become more lottery‐like, arbitrage risk increases, resulting in higher overpricing (underpricing) in high (low) relative short interest (RSI) stocks. Monthly portfolio alphas are –1.61% for high RSI lottery stocks, whereas high RSI stocks with the least lottery‐like attributes show statistically insignificant alphas. Among lightly shorted stocks, lottery securities exhibit monthly alphas of 1.80%. Thus, although lottery stocks as a group typically underperform, investors can earn positive abnormal returns in lightly shorted lottery stocks. Our results suggest that lottery stocks’ greater noise trader risk and higher transactions costs impedes arbitrage in short interest‐related mispricing.