Forecast dispersion and the cross section of expected returns

Research output: Contribution to journalArticlepeer-review

Abstract

Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' earnings forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when 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.

Original languageEnglish (US)
Pages (from-to)1957-1978
Number of pages22
JournalJournal of Finance
Volume59
Issue number5
DOIs
StatePublished - Oct 2004
Externally publishedYes

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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