Idiosyncratic risk,costly arbitrage,and the cross-section of stock returns |
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| Institution: | 1. The Chinese University of Hong Kong, Hong Kong;2. Rotman School of Management at the University of Toronto, Canada; Southwestern University of Finance and Economics, China;1. School of Demography, The Australian National University, ACT 2601, Australia;2. Research School of Finance, Actuarial Studies and Statistics, The Australian National University, ACT 2601, Australia;1. The Smeal College of Business, The Pennsylvania State University, 322 Business Building, University Park, State College, 16801, Pennsylvania, USA;2. Department of Finance, John Molson School of Business, Concordia University, 1455 de Maisonneuve Blvd. West, Montreal, P.Q., H3G 1M8, Canada |
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| Abstract: | 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. |
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