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Forecast dispersion and the cross section of expected returns

Subject

Finance

Publishing details

Authors / Editors

Johnson T

Publication Year

2003

Abstract

Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when underlying asset values are unobservable. The relationship then follows from a general options-pricing result: for a levered firm, expected returns should always decrease with the level of idiosyncratic asset risk. This story is formalized with a straightforward model. Reasonable parameter values produce large effects, and the theory's main empirical prediction is supported in cross-sectional tests.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 393

Series

IFA Working Paper

Available on ECCH

No


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