You are on page 1of 43

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

Rodney D. Boehme, Bartley R. Danielsen, Praveen Kumar, and Sorin M. Sorescu* This version: March 15, 2005

Abstract Merton (1987) predicts that idiosyncratic risk should be priced when investors hold suboptimally 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.

_______________________________ * Boehme is from W. Frank Barton School of Business at Wichita State University. Danielsen is from
the Kellstadt College of Commerce at DePaul University. Kumar is from the C.T. Bauer College of Business, University of Houston. Sorescu is from Mays Business School at Texas A&M University. This paper has benefited from the comments of Fred Arditti, Mark Flannery, Anna Scherbina, Stephen C. Vogt of Mesirow Financial, Kevin Mirabile of Saw Mill Management and Research as well as seminar participants at Texas A&M University and the University of Kansas. Please address correspondence to Kumar at the C.T. Bauer College of Business, University of Houston, Houston, TX 77204-6021, phone (713) 743-4770, e-mail: pkumar@uh.edu. Data on analysts forecasts was provided by I/B/E/S Inc., under a program to encourage academic research.

Idiosyncratic Risk and the Cross-Section of Stock Returns: Merton (1987) Meets Miller (1977)
Abstract Merton (1987) predicts that idiosyncratic risk should be priced when investors hold suboptimally 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.

1. Introduction
According to the textbook capital asset pricing model (CAPM), idiosyncratic risk is not priced because investors hold efficiently diversified portfolios. However, the model makes no predictions concerning the effect of idiosyncratic risk on equilibrium returns if investors are constrained from forming diversified portfolios due to transactions costs---for example, information or trading costs. In an influential paper, Merton (1987) presents an extension of the CAPM where idiosyncratic risk plays a role in equilibrium. Investors in Mertons model suffer from extreme information costs and only hold securities with which they are familiar. Consequently, they hold under-diversified portfolios and demand compensation for securities idiosyncratic risk.1 Therefore, in equilibrium, cross-sectional stock returns are positively related to their idiosyncratic risk. Direct tests of Mertons (1987) model are rare. Mertons predictions are cross-sectional in nature, but Ang, Hodrick, Xing and Zhang (2004) appear to be the only cross-sectional test of Merton (1987) that directly sorts stocks into portfolios ranked on idiosyncratic volatility. Observing that stocks with high idiosyncratic volatility have abysmally low average returns, they conclude their results are directly opposite the Mertons theory. Diether, Malloy and Scherbina (2002) offer an indirect test of Merton (1987). Since dispersion in analysts forecasts likely indicates a more volatile, less predictable earnings stream, Diether et al. (2002) suggest that the dispersion of analysts forecasts reflect the type of idiosyncratic risk to which Merton refers. Indeed, idiosyncratic volatility and dispersion of

Levy (1978) and Mayers (1976) produce similar predictions in CAPM extensions where investors hold under-diversified portfolios. Barberis and Huang (2001) produce a prospect-theory model where idiosyncratic risk produces positive expected returns.

analysts forecasts have been shown to be positively correlated.2 Their results do not support Mertons theory, and they note our results clearly reject the notion that dispersion can be viewed as a proxy for risk, since the relation between dispersion and future returns is strongly negative (page 2139). Similarly, when Gebhardt, Lee and Swaminathan (2001) use forecast dispersion as a risk proxy for estimating cost of capital, they are surprised to find the wrong sign on the variable at statistically and economically significant levels. Thus, both in direct tests using idiosyncratic volatility as a proxy for idiosyncratic risk, and in indirect cross-sectional tests that use analysts forecast dispersion as a risk proxy, crosssectional results are incorrectly signed at high levels of significance compared to Mertons (1987) predictions. Based on the empirical tests to date, the literature concludes that Mertons hypothesis, while both intuitively appealing and theoretically well grounded, is not supported by the data. In fact, Diether et al. (2002) argue that their results, along with those of Gebhardt et al. (2001), are more consistent with predictions by Miller (1977). Miller (1977) argues that dispersion of opinion, in the presence of short sale constraints, leads to systematic security overvaluation because the most optimistic market participants set a stocks price. Thus, dispersion of investor opinion is priced at a premium when short sale

constraints are present. The implication of Millers (1977) theory is that a negative correlation exists between risk-adjusted returns and dispersion of beliefs, if short sale constraints are binding. Indeed, several other theoretical papers derive similar asset pricing predictions. A non-exhaustive set includes Figlewski (1981), Morris (1996), Viswanathan (2002), Chen, Hong and Stein (2002), Danielsen and Sorescu (2001), and Duffie, Garleanu and Pedersen (2002).3

Empirically, Peterson and Peterson (1982) observe a positive relationship between return volatility and the dispersion of I/B/E/S forecasts, and we confirm their finding later in this study. Diamond and Verrecchia (1987) and Jarrow (1980) provide alternative theories of short-sale constraint effects. Diamond and Verrecchia model security prices in a rational expectations framework that precludes the possibility of systematic mispricing. However, changes in observed, costly short-sales are informative and result is learning that changes asset prices. Jarrow (1980) develops a general equilibrium model which recognizes cross-effects in addition to own-effects.

The observed negative correlation between returns and analyst forecast dispersion (Diether et al. (2002)) is interpreted as supportive of Miller (1977), but contrary to the predictions of Merton (1987), because the dispersion of analysts forecasts and idiosyncratic volatility are positively correlated. However, there are strong reasons to question whether Merton (1987) should be viewed as a competing theory to Miller (1987). While Miller (1977) assumes that stocks are short-sale constrained, Merton (1987) models a standard frictionless market, without borrowing and shortselling restrictions (page 487). Absence of frictions is, in fact, crucial for Mertons (1987) prediction of a positive relationship between equilibrium returns and idiosyncratic risk. In this paper, we re-visit Mertons (1987) model and explicitly allow for short-sale constraints. We find that the models predictions on the relationship of equilibrium returns to idiosyncratic risk are ambiguous if the short-sale constraints are binding. Because investors hold under-diversified portfolios, absence of shorting constraints is crucial in order for the market to impound private differential information about the relative value of securities into an unbiased, efficient estimate. Viewed in this light, Miller (1977) and Merton (1987) are complementary. Miller (1977) applies to short-sale constrained firms, and Merton (1987) is applicable to stocks where the short-sale constraint is not binding. Empirical tests that fail to distinguish between short-saleconstrained firms and firms that are unlikely to be subject to such constraints are neither appropriate for tests of Merton (1987), nor for tests of Miller (1977). Johnson (2004) provides an option-theoretic interpretation of the observed negative relationship between returns and idiosyncratic risk. For a levered firm, equity returns will decrease with idiosyncratic asset risk due to convexity. Because analyst dispersion is correlated
Both underpricing and overpricing for individual stocks can result from market-wide short sale prohibitions in this framework.

with idiosyncratic asset risk, equity returns will decrease with higher analyst forecast dispersion also. As Johnson notes (page 1958), the option-theoretic model and the Millers (1977) shortsale-constraint theory produce parallel predictions. However, because these theories are not mutually exclusive, they are not in conflict. Both effects can exist simultaneously. In this paper, we focus on resolving the apparent contradiction between Merton (1987) and Miller (1977) which we argue to be spurious and use a short-sale constraint filter, rather than the leverage filter used by Johnson. We analyze the cross-sectional relationship between idiosyncratic risk and equity returns by carefully controlling for the likelihood of binding shorting constraints. For robustness, we use several proxies, based on the recent literature, to identify the degree of short-sale constraints. We find that cross-sectional returns are positively correlated with idiosyncratic volatility for stocks that are unlikely to be subject to shorting constraint, as predicted by Merton (1987). Moreover, returns are also positively correlated with the dispersion of analyst forecasts, a finding that is also consistent with Merton (1987), to the extent that analyst dispersion reflects the type of idiosyncratic risk to which Merton refers (see, e.g., Diether et al., 2002).4 To clarify the role of binding short-sale constraints in the relation of returns and idiosyncratic risk, we also examine firms that are likely subject to short-sale constraints. Not surprisingly, perhaps, we find strong support for the Miller (1977) hypothesis here. Firms with high dispersion of analysts forecasts earn negative abnormal returns, and firms with high idiosyncratic volatility under-perform on a risk-adjusted basis. This result is consistent with relatively weak support for the Miller hypothesis during the 1990s found by Diether, Malloy and Scherbina (2002), where Millers hypothesis is tested as a competitor to Mertons
4

We note that the finding is also consistent with Varian (1985) who predicts discount pricing when dispersion of investor beliefs exists in the absence of short-sale constraints.

hypothesis. More recently, both Boehme, Danielsen and Sorescu (2005) and Asquith, Pathak and Ritter (2005) find stronger support for Millers theory during the 1990s by explicitly recognizing the important interaction of short-sale-constraints with dispersion of beliefs. Our analysis differs from these two papers in that it reflects the importance of screening out shortsale-constrained firms when testing Mertons hypothesis that firms with high idiosyncratic risk will be priced at a discount. The rest of this paper is organized as follows. Section 2 extends the Merton (1987) to allow for short-sale constraints, and discusses the proxy variables we use for dispersion of beliefs, idiosyncratic risk, and short-sale constraints. Section 3 discusses the testing

methodology and the data. Section 4 presents base-line cross-sectional effects without regard to short-sale constraints. Section 5 presents empirical tests of Merton (1987) for firms that are free of short-sale constraints. Section 6 repeats the analysis for short-sale constrained firms in accordance with the Miller (1977) hypothesis. Section 7 summarizes and concludes with a graph providing a more holistic analysis of the cross-sectional effects of idiosyncratic volatility and dispersion of beliefs.

2. Capital Market Equilibrium with Incomplete Information and Shorting Constraints


We extend the Merton (1987) model to allow for constraints on short-selling. For consistency and ease of reference, we maintain Mertons basic model structure and notation. There is one investment period and n firms in the economy. The equilibrium return per dollar from investing in firm k, Rk , is given by the one-factor model: Rk = E ( Rk ) + bk Y + k k , (1)

where Y is a random common factor whose unconditional expectation is zero and variance is unity, and E ( k ) = E ( k 1 ,..., k 1 , k +1 ,..., n , Y ) = 0. There is a riskless security (the (n+2) security) with sure return per dollar R and another security (the (n+1) security) that combines the riskless security with cash settlement on the observed factor Y. Taking the standard deviation of equilibrium return on this security to be unity, we can write this return as, Rn +1 = E ( Rn +1 ) + Y . (2)

Both the riskless and the forward contract security are inside securities; i.e., their aggregate demand sums to zero. There are no taxes and transactions costs, and that investors can borrow and lend without restriction at the same rate. However, and by contrast to Merton (1987), we disallow shortselling of the firms shares. There are N price-taking and risk-averse investors who select optimal portfolios according to the Markowitz-Tobin mean-variance criterion. Hence, the preferences of investor j = 1,N, can be represented as, U j = E ( R jW j )

j
2W
j

Var ( R jW j ),

(3)

where W j is the investors investible wealth (equal to his or her initial endowment of shares in the firms evaluated at equilibrium prices); R j denotes the return per dollar on the portfolio; and, j > 0. While the riskless return and the mean and variance of the return of the forward contract security are common knowledge, a typical investor only knows the parameters of the factor return model, given in (2), for a subset of securities. Specifically, an investor is said to know about security k = 1,,n, only if he or she knows the triple ( E ( Rk ), bk , k2 ). For each investor, j = 1,N, there is associated a collection of integers J j , such that k belongs to J j , only if the 6

investor knows k (in the sense specified above). As in Merton (1987), the key behavioral assumption is that investor j includes security k only if k J j . To set up the typical investors portfolio optimization problem, let kj (k = 1,2,n+2) denote the faction of investible wealth allocated to security k by investor j. Then, using (1) and (2), the portfolio returns are, R j = E(R j ) + b jY + j j , where, b j 1 kj bk + nj+1 , j
n

(4)
j k

(
n 1

) 2 k2 , and j 1 kj k k / j .
n

Since the

portfolio weights must sum to one, with judicious substitutions, we can write the variance and expected return on the portfolio as (see, Merton (1987)), Var ( R j ) = (b j ) 2 + ( j ) 2 , E ( R j ) = R + b j ( E ( Rn +1 ) R) + kj k ,
1 n

(5) (6)

where, k E ( Rk ) R bk ( E ( Rn +1 ) R). Then the optimal portfolio is the solution to the constrained maximization problem,

j n n Max{b j , j } E ( R j ) Var ( R j ) 1 kj kj + 1 kj kj . 2

(7)

Here, kj is the Kuhn-tucker multiplier reflecting the constraint that the investor j cannot include security k in his or her portfolio if k does not belong to J j , while kj is the KuhnTucker multiplier reflecting the constraint that the investor cannot short-sell security k. We note that kj = 0 if k J j . But if k J j , then kj = 0 and kj = 0. The first order conditions for (7) are, for k = 1,2,n. 0 = E ( Rn +1 ) R j b j (8.a)

0 = k j kj k2 kj + kj .

(8.b)

From (8.a) and (8.b), the optimal b j = [ E ( Rn +1 ) R] / j , and the optimal portfolio weights for assets in the known set, i.e., k J j , are:

=
j k

k + kj

j k2

,
n n

(9)

with kj = 0 for k J j , nj+1 = b j 1 kj bk , and nj+ 2 = 1 b j 1 kj (bk 1).

If

we

assume identical preferences and wealth across agents, then investors will choose the same exposure to the common factor b j = b,1..., N , and hence, in equilibrium, E ( Rn +1 ) = R + b. (10)

Next, we can aggregate security demands across agents to yield the aggregate demand for firms shares; i.e., for k = 1,n, Dk = N k W ( k + 1 kj )
N

k2

(11a)

where N k denotes the number of investors who know security k. Furthermore, Dn +1 = NWb 1 Dk bk , Dn + 2 = NWb 1 Dk .
n n +1

(11b)

We note that the aggregate share demand given in (11) differs from Merton (1987) due to the presence of shorting constraints. As seen in (11a), if the shorting constraints for security k = 1,n, are binding, then the aggregate demand is strictly larger (in algebraic terms) compared to the situation where there are no shorting constraints. To derive the equilibrium returns on firms share, let M denote the aggregate wealth, and let x k denote the fraction of aggregate wealth invested in security k = 1,n. Finally, put

qk =

Nk

, i.e., the fraction of investors who know about security k. Then, market clearing

requires that, xk = q k ( k + 1 kj )
N

k2

(12)

Using (10), (12), and the definition of k in (6), we can write the equilibrium expected return for (6b) as, E ( Rk ) = R + bk b + k . Using the equilibrium condition (12), we can substitute for k to write, E ( Rk ) = R + bk b +

x k k2 N j k qk j =1

(13)

The last term in (13) can be interpreted as the Miller (1977) effect: if shorting constraints are binding, then the expected return on a security falls since the current price reflects the beliefs of the most optimistic investors.5 Moreover, (13) shows that the relationship between equilibrium returns and idiosyncratic risk (i.e., k2 ) is ambiguous. The reason is that whether the shorting constraints bind or not (i.e., whether kj > 0 or kj = 0 ) itself depends on k2 . Indeed, one can argue that shorting constraints are more likely to bind for new securities, since the supply of such securities is usually curtailed (see, e.g., Miller (1977) and Houge, Loughran, Suchanek, and Yan, (2001)). But we would also expect the idiosyncratic risk on these securities to be higher. Hence, the last two terms in (13) would both increase with k2 , and hence the net effect of an increase in k2 on equilibrium returns would be ambiguous.

Of course, and exactly as in Merton (1987), we have not formally incorporated heterogeneity of beliefs for notational ease. But the foregoing analysis is readily extended to the case where expectations are investor specific.

3. Hypotheses, Explanatory Variables, and Test Design


The foregoing analysis, along with a reading of Miller (1977), suggests the following complementary hypotheses that we test in this study: 1(a). The Merton Hypothesis. Cross-sectional differences in idiosyncratic volatility

are positively correlated with subsequent returns when short-sale constraints are likely to be non-binding. 1(b). A cross-sectional pattern similar to 1(a) will exist for I/B/E/S forecast

dispersion with high dispersion firms earning higher risk-adjusted returns because idiosyncratic risk and dispersion of analyst forecasts is highly correlated. 2(a). The Miller Hypothesis. Cross-sectional differences in I/B/E/S forecast

dispersion are negatively correlated with subsequent returns when short-sale constraints are binding. Moreover, the value premium accompanying dispersion of beliefs will increase as the level of short-sale constraints increase. 2(b). A cross-sectional pattern similar to (2a) will exist for idiosyncratic volatility

because idiosyncratic risk and dispersion of analyst forecasts is highly correlated. We now describe the independent (or explanatory) variables used in the analysis, as well as our methodology for measuring stock returns.

A. Explanatory Variables A.1 Short Sale Constraint Proxies Previous research suggests several proxies for the degree to which stocks are short sale constrained. These include the presence of exchange-traded options, and the level of short interest relative to shares outstanding.

10

A.1.1 Option Status Several studies have documented that firms with traded options are, in general, less short-saleconstrained than firms without options (see, e.g., Figlewski and Webb (1993); Danielsen and Sorescu (2001); Boehme, Danielsen and Sorescu (2005), and Evans, Geczy, Musto and Reed (2003)). The intuition behind options relaxing short-sale constraints is that options allow investors to take short positions in securities without short selling directly. Boehme, Danielsen and Sorescu (2005) observe that the securities lending market for stocks is unusually opaque with active participants paying much lower fees than less active ones. Investors who might short-sell at a relatively high cost instead can use options to synthetically short a security. Option market makers, as the counter-party to these synthetic short sales, are left with synthetic long positions, which they hedge by borrowing the stock and shorting it. As frequent

participants in the short-sale market, option market makers can execute and maintain short positions at much lower costs than infrequent short sellers. This short-sale cost advantage is reflected in competitively priced options.6 Consistent with the idea that options facilitate short selling, Figlewski and Webb (1993) report that short interest levels increase after option introductions. Also, Boehme et al. (2005) report that stock lending fees for firms with traded options are lower than for non-optioned stocks. Moreover, the difference in fees is greater between optioned and non-optioned firms when the level of short interest is unusually high. A.1.2. Relative Short Interest Short interest is perhaps the longest-used and most common short-sale-constraint proxy in past studies. Figlewski (1980) first proposed this proxy, hypothesizing that as the level of observed

Evans, Geczy, Musto, and Reed. (2004) and Danielsen and Sorescu (2001) provide more in-depth discussion of the options market making process and its relevance to short-sale constraints.

11

short sales increases, the unobserved demand to short the security probably rises as well. Thus, firms that are highly shorted are, at the margin, the most difficult to short. Diamond and Verrecchia (1987) produce a theoretical justification for why observed short interest may proxy for unfulfilled demand to short. Recently, DAvolio (2002) produces

empirical support for Figlewskis intuition and Diamond and Verrecchias theoretical affirmation. DAvolio finds that the most heavily shorted stocks are more costly to short, on average, and also contain a higher percentage of stocks that are on special.7 DAvolio also reports that the differences in short-selling costs, as measured by rebate rates, are very small for firms below the first four deciles [See DAvolio (2002) Figure 1]. DAvolios finding is confirmed by Boehme, Danielsen and Sorescu (2005) using an alternative source for rebate rate data. The observations made by DAvolio (2002) and Boehme, Danielsen and Sorescu (2005) seem to be already known to professional short sellers who describe a practice they refer to as locking up the borrow. Locking up the- borrow involves shorting a security and

simultaneously taking a long position in the same security.8 The motivation for this behavior is that professional short sellers fear the cost of borrowing shares will rise, or the shares will become impossible to borrow at a later date as other parties begin to take short positions in the security (i.e. as short interest rises). Parties who have locked up the borrow can add to their short positions by selling part of the long position instead of by shorting additional shares. By locking up the borrow, short sellers are actually locking in lower future short sale costs since security lenders are reluctant to request that good customers return their shares when share supply becomes tight. Even though a new party might be willing to borrow for
7

DAvolio finds that the level of short-sale constraint is monotonically increasing in short interest, except for stocks in the least-shorted decile, which are, on average, more costly to short than stocks in the second decile of reported short interest. This practice is also known as shorting against the box.

12

some short period at a very high price (i.e. low rebate), the lender values the long-term relationship with a regular customer. In these cases, rationing, rather than price alone, may be used to clear the market. The rationing process favors those who previously locked up the borrow. 9 It is interesting to note that, at least in theory, a shortage of shares could arise precisely because many parties have locked up the borrow. In any event, the practice suggests that professional short sellers recognize marginal borrowing prices will rise as more shares are shorted. A.2. Idiosyncratic Risk

We measure idiosyncratic risk as the standard deviation of the error terms from the Brown and Warner (1985) market model, estimated over the 100 days preceding the first day of the month for which the short interest data are reported.10 This measure is analogous to k2 , the firm-specific component of the firms return variance, in Merton (1987).

A.3.

I/B/E/S Dispersion of Opinion We measure dispersion of beliefs using the coefficient of variation for analysts annual

forecasts estimated from I/B/E/S data. The coefficient of variation is estimated by dividing the I/B/E/S reported standard deviation of analyst earnings/share forecasts for the current fiscal year end (I/B/E/S FY period 1) by the absolute value of the mean earnings/share forecast, as listed in the I/B/E/S Summary History file. Diether et al. (2002) use this proxy.

We thank Stephen C. Vogt, Managing Director, Mesirow Financial for his insights on the institutional practices of sophisticated short sellers and market-neutral fund managers. Firms are excluded from our analysis in any month if more than 10 days of returns data or 75 days of volume data are identified as missing on CRSP in the prior 100 days or if the firm is missing RSI data. We also screen out all securities other than domestic common stocks.

10

13

Diether et al. (2002) note that the standard I/B/E/S forecast file contains an error related to rounding of historical split-adjusted values. Therefore, we obtained upon special request from I/B/E/S a separate file containing analyst forecasts that are unadjusted for historical stock splits, and therefore do not suffer from this potentially serious rounding error. We compute our coefficients of variation using this unadjusted file, which is the same as the one employed by Dither et al. (2002). We note, however, that I/B/E/S analyst dispersion data suffers from a limitation in that at least two analysts must follow the stock for a dispersion value to be computed. As noted in Diether et al. (2002), only relatively large firms have two or more analysts providing forecasts. In fact, Danielsen and Sorescu (2001) report that among the firms that have sufficient liquidity for traded options to be introduced, nearly one third had fewer than two analysts per the I/B/E/S database. Thus, I/B/E/S dispersion cannot be calculated for many small firms. B. Measuring Subsequent Stock Returns We adopt the standard four-factor, calendar-time portfolio approach for measuring abnormal returns. For each month in the calendar during the 1988 to 2002 period, we use our explanatory variables to classify firms in the two-dimensional space spanned by the severity of the short-sale constraints and the idiosyncratic risk (or I/B/E/S analyst dispersion). Firms with similar values on each dimension are grouped into equally-weighted portfolios. For each portfolio, we first calculate the monthly raw returns during the month subsequent to the portfolio formation. For robustness, we also examine monthly returns for portfolios where firms are held for 12-month, rather than one-month, periods. For each portfolio we estimate the following four-factor regression model: Rp,t - Rf,t = p + p(Rm,t - Rf,t) + spSMBt + hpHMLt + upUMDt +ep,t (14)

14

where Rp,t represents the raw returns of each portfolio, and Rf,t is the return of the one-month Treasury Bill. The four independent variables are the excess return on the market portfolio (Rm,t-Rf,t), the difference between the returns of value-weighted portfolios of small and big firm stocks (SMBt), the difference in returns of value-weighted portfolios of high and low book-tomarket stocks (HMLt), and the difference in returns of value-weighted portfolios of firms with high and low prior momentum (UMDt, or up minus down). The first three factors are proposed by Fama and French (1993), while the momentum factor is proposed by Carhart (1997).11 The intercept, p, from equation (14) is interpreted as the mean monthly abnormal

return of the calendar time portfolio. Because the number of firms in a portfolio can change monthly, we use WLS procedures to weight the calendar-time portfolios on the basis of the number of firms in a portfolio each month. Our most important tests compare returns between the calendar time portfolios in highand low-idiosyncratic-risk (or dispersion-of-opinion) securities. We perform these tests by constructing hedge portfolios with long positions in high-dispersion stocks and short positions in low-dispersion stocks. The hedge portfolio returns are regressed on the four factors: Rhigh-dispersion,tRlow-dispersion,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t (15)

The "hedge" intercept obtained in this manner (p) represents a measure of the relative longterm abnormal performance of high-dispersion firms vis--vis the low-dispersion control sets after controlling for short-sale constraint levels.12

11

The four factors are made available by Kenneth French on his website at Dartmouth College. The momentum factor is used because Fama and French (1996) and Carhart (1997) document a momentum bias for the "traditional" three-factor model. This follows a procedure similar to that proposed by Mitchell and Stafford (2000) and implemented by Boehme and Sorescu (2002).

12

15

C. Data Sources Our sample is composed of all firms for which short interest data is electronically available. Short interest data have been obtained from the New York Stock Exchange and the NASD. Short interest on both NYSE and Nasdaq firms is available in electronic form

beginning with January of 1988. All short interest data are collected on a monthly basis for transactions settling by the 15th of each month. Following Boehme, Danielsen and Sorescu (2005), we use the ticker symbols shown in the short interest reports to match each observation with the CRSP data.13 As is standard practice when using short interest data, we scale each observation by the number of shares outstanding. We refer to the scaled data as relative short interest (RSI), the percentage of each firms outstanding shares that are held short.
D. Descriptive Statistics

Table 1 provides descriptive statistics for the proxy variables used. We provide a snapshot of firms in our dataset at five-year intervals. The idiosyncratic risk proxy, SIGMA, appears to have been smaller prior to 1988, but since January 1988, no clear pattern is evident in the data. As we will discuss later, most of our tests are conducted for the post-1987 period, due to the lack of short-sale-constraint data prior to 1988. We possess I/B/E/S analyst dispersion data beginning in February 1976, and the table reports statistics for DISPERSION beginning in 1978. No clear pattern exists in the

DISPERSION data. The anomalous I/B/E/S mean for December 2002 is driven by one
13

We noticed short interest data are occasionally missing for firms with valid CRSP data. We do not include such observations in our sample because we are unable to determine if they represent a zero level of short interest, or if short interest data are missing. Moreover, assuming that at least some of these missing observations represent a zero level of short interest, DAvolios (2002) findings suggest that it is preferable to exclude these firms, because the relation between short interest and short sale constraints is monotonically positive except for firms in the lowest short interest decile. By excluding these missing observations, we are reasonably confident that the empirical relation between relative short interest and short sale constraints is monotonically positive in our remaining sample, a fact that has been empirically verified by Boehme, Danielsen and Sorescu (2005).

16

extreme outlier, which has a DISPERSION measure of 2000. Notice that the 99th percentile value is reasonable. Because portfolios are formed on the basis of rank-ordered SIGMA and DISPERSION, a small number of extreme values for SIGMA or DISPERSION will not have an out-sized influence on portfolio returns. RSI and OPTIONS data are reported beginning in 1988, the date when RSI data becomes available in electronic form. The proportion of firms with exchange-traded options rises dramatically over the period, as does the mean and median RSI.

4. Baseline Cross-Sectional Tests


Table 2 presents baseline cross-sectional tests of the effects of idiosyncratic risk, without regard to short-sale constraints. Calendar time portfolio (one and twelve month horizons) abnormal returns are shown as a function of idiosyncratic risk (SIGMA) and analyst earnings forecast dispersion (DISPERSION) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms. SIGMA is the standard deviation of the error term obtained from the Brown and Warner (1985) market model regression computed over the prior 100 days of stock returns. SIGMA quartiles are reassigned each month. DISPERSION is measured by dividing the I/B/E/S standard deviation of analyst earnings/share forecasts for the current fiscal year end (I/B/E/S FY period 1) by the absolute value of the mean earnings/share forecast, as listed in the I/B/E/S Summary History file. Observations having a mean earnings forecast of zero are omitted for the purpose of assigning the rank ordering of firms. DISPERSION quartiles are assigned for each month. Firms having a mean forecast of zero are then assigned to the highest DISPERSION quartile. Quartiles 1 and 4 are the lowest and highest SIGMA and DISPERSION quartiles, respectively.

17

The abnormal returns are computed by forming equally-weighted calendar-time portfolios, of either one-month or twelve-month horizons, and regressing the excess portfolio returns (Rp,t-Rf,t) on the four factor model described above. Calendar time portfolios are rebalanced each month, and the portfolios include only firms that entered the portfolio during either the prior month or the previous twelve months. Monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the regression. The abnormal return of the hedge (or zero-investment) portfolio is also shown. This hedge portfolio consists of long positions of stocks in the highest quartile stocks and short positions in the lowest quartile ones. The p-value of the hedge portfolio report the statistical difference of the measured mean return from zero. Panel A of Table 2 presents results for the period from 1988 to 2002, which is used throughout the rest of the paper. As can be observed in the table, hedge returns for portfolios formed on the basis of idiosyncratic risk earn negative returns in one-month portfolios, and positive returns in the twelve-month portfolios. These results are not statistically significant. I/B/E/S one-month hedge portfolio returns are negative and statistically significant. This result is consistent with Diether et al. (2002) and suggests that Millers hypothesized overpricing is detected in the returns. The twelve-month I/B/E/S hedge portfolio returns are also negative, but they are not statistically significant. Certainly, as others have noted, there is no evidence here to support Mertons hypothesis. In Panels B and C we repeat the tests using longer sample periods to include volatility measures dating back to January 1963, and I/B/E/S dispersion measures dating back to 1976. We find no qualitative difference in the results over these longer periods.

18

5. The Merton Space: Short-Sale Constraints Absent


Having established a baseline for the cross-sectional effects of idiosyncratic risk, we now turn attention to the subset of firms where Mertons theorized positive correlation between idiosyncratic risk and return is most likely to be found; firms without short-sale constraints. Recall that we use two proxies for the presence of short-sale constraints. First, the presence of options, and second the relative short interest level. The presence of exchange-traded options is binary. Firms either have exchange-traded options or they do not. In contrast, RSI is a continuous variable. Boehme et al. (2005) observe that although firms with options have lower costs of short selling than those without options, even among optioned firms short-sale constraints on average are lower for less shorted securities. Accordingly, among firms with exchange-traded options, we should expect that a Merton effect would be more pronounced when high RSI firms are excluded from the sample. With this in mind, we formulate the following test: Each month, we rank all firms on the basis of RSI and sort them into twenty groups (viciles) with 5% of firms in each vicile. Vicile 20 contains the 5% of firms having the largest RSI that month, and Vicile 1 contains the firms with the smallest monthly RSI. We then repeat the cross-sectional tests shown in Table 1, the baseline test, for nested subsets of optioned firms, with the largest cross-sectional test being applied to a portfolio of firms containing Viciles 1 through 20; in other words, to all optioned firms. The second cross-sectional test is identical to the first, except that only RSI Viciles 1 through 19 are included in the portfolios. The third test if for Vicile groups 1 through 18, and so on. Using this method we can observe the effect of peeling away firms that are more likely to face shorting constraints as measured by the RSI proxy. We expect that the correlation between idiosyncratic risk and return to be higher as the highest RSI viciles are eliminated. 19

We focus on the returns to the hedge portfolio that is long on firms with high idiosyncratic volatility and short on firms with low idiosyncratic volatility. These hedge returns provide a good measure of the price effect of idiosyncratic volatility. If Mertons (1987) model is correct, the hedge returns should be positive for stocks that are free of short sale constraints. Figure 1 is a graphical depiction of the one-month calendar-time hedge portfolio returns, along with p-values.
1.60% Monthly Abnormal Return 1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 20 19 18 17 16 15 14 13 12 Size of Largest RSI Vicile in the Portfolio % Return P-Value 0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50

Figure 1: Hedge Portfolio Abnormal Returns and P-Values (Idiosyncratic Risk) The left-most observation (20) includes all RSI viciles, and thus all firms with traded options. The right-most portfolio (12) is composed of firms only in Viciles 1-12. As

previously discussed, Viciles 1 through 12 are relatively homogenous, and less than one-fourth the sample are in viciles less than 12. It is immediately obvious that, in contrast to the baseline hedge portfolio that earned significant negative abnormal returns, Portfolio 20, the hedge portfolio for all optioned stocks does not. The abnormal return, measured along the left axis, is -0.001% per month, a value which is neither economically nor statistically significant. 20

P-Value

Consistent with Merton (1987), as we begin to exclude firms that are likely to be subject to short-sale constraints, the hedge portfolio abnormal returns become more positive, and the pvalues rise in significance. Excluding firms with RSI in the highest 10% for the month (viciles 19 and 20), the abnormal return jumps to 0.61% per month, and the p-value is 14.6%. Including only firms with RSI viciles 1 though 15 produces abnormal returns of 1.1% per month (p-value = 0.049). This is a very high abnormal return in an economic sense, more than 13% annually. For portfolio 12 the returns is even higher at 1.42% per month (p-value = 0.024).14 These results are completely consistent with the predicted positive correlation between idiosyncratic risk and abnormal returns as predicted in Merton (1987). As firms likely to have the highest levels of short-sale constraint are excluded from the portfolio, the effect of idiosyncratic volatility on abnormal returns becomes more positive. Table 3 presents the data in Figure 1 along with individual quartile results. The format is the same as that used in the baseline results in Table 2. Notice in particular that the increase in hedge portfolio returns for Portfolio 12, relative to Portfolio 20, is driven entirely by increased returns for the high idiosyncratic risk quartile. The low idiosyncratic risk quartile does not evidence falling returns. As firms that are more likely to be short-sale constrained are excluded from the sample, the firms with higher idiosyncratic risk exhibit the behavior predicted by Merton (1987). We next turn to an analysis of the I/B/E/S dispersion data. Diether et al. (2002) suggest that the dispersion of analysts forecasts reflect the type of idiosyncratic risk to which Merton refers. Using I/B/E/S forecast dispersion, they reject Merton (1987) in favor of Miller stating, our results clearly reject the notion that dispersion can be viewed as a proxy for risk, since the

14

Because we examine only firms with traded options, the lowest RSI viciles are very thinly populated. Optioned firms tend to be larger and to have higher levels of short interest. [See Figlewski and Webb (1977)] Less than 25% of firms with exchange-traded options fall into Viciles 1 through 12.

21

relation between dispersion and future returns is strongly negative. Likewise, Gebhardt et al. (2001) note that forecast dispersion has the wrong sign to be a risk proxy useful in estimating the cost of capital. It certainly seems appropriate to suspect that the dispersion of analyst forecasts would be related to idiosyncratic risk levels. Numerous authors present theoretical models correlating belief dispersion with asset time-series volatility. For example, Shalen (1993) and Harris and Raviv (1993) develop models that specifically investigate the role of belief dispersion on volatility and other trading characteristics. Empirically, Peterson and Peterson (1982) observe a positive relationship between return volatility and the dispersion of I/B/E/S forecasts. In our sample, we find the correlation between I/B/E/S dispersion and idiosyncratic risk has a correlation of 0.3521. Repeating the methodology depicted in Figure 1, we present Figure 2 showing the hedge portfolio abnormal returns and p-values for I/B/E/S forecast dispersion.

22

0.60% Monthly Abnormal Return 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% 20 19 18 17 16 15 14 13 12 Size of Largest RSI Vicile in the Portfolio % Return P-Value

0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50

Figure 2: Hedge Portfolio Abnormal Returns and P-Values (I/B/E/S Dispersion) In a manner similar to the results depicted in Figure 1, I/B/E/S dispersion is positively correlated with hedge portfolio alphas. Ignoring the RSI viciles for the moment, but

restricting the analysis to firms with traded options only, the abnormal returns reported for Portfolio 20 are positive, but not statistically significant. This is in contrast to the findings in Table 2 where a negative and statistically significant correlation is observed between IBES dispersion and abnormal returns. Stripping away the highest RSI viciles, hedge portfolio returns and p-values rise in a manner similar to that found in the idiosyncratic risk tests. Portfolio 12 reports monthly abnormal returns of 0.51% (p = 0.054), which annualizes as 6.3% per year. These results, reported numerically in Table 4, strongly support Mertons hypothesis. They stand in keen contrast to previous tests pitting Merton (1987) as a

competing hypothesis to Miller (1977).

23

P-Value

We have also conduct the tests reflected in Figures 1 and 2 using one-year, as opposed to one-month, calendar-time portfolios. These results are not significantly different from those presented above. We infer the Merton risk premium is not rapidly dissipated, but persists for an extended time-period.

6. The Miller Space: Short-Sale Constraints Present


We now turn to examining the price effect of idiosyncratic risk when short-sale constraints are present: the Miller space. We first examine the cross-sectional effects of dispersion-of-opinion as proxied by I/B/E/S estimates. In an explicit sense, Merton (1987) hypothesized that idiosyncratic volatility is priced at a discount. Diether et al. (2002) and other empiricists infer that the dispersion of analysts forecasts reflects a type of idiosyncratic risk to which Merton refers. In contrast, Miller (1977) explicitly considers the dispersion of investor beliefs. While Jones, Kaul and Lipson (1994), among others, note that volatility is related to the dispersion of beliefs, I/B/E/S forecast dispersion more intuitively reflects the dispersion of beliefs to which Miller refers. In the Miller space, dispersion of beliefs should result in premium pricing, in contrast to the discount pricing in the Merton space. The following tests mirror those conducted in the previous subsection with the following modifications. As a first screen, because we wish to examine short-sale constrained securities rather than unconstrained ones, we examine firms without traded options. From this set of option-less firms, we further refine the screen using the RSI vicile classifications previously described. Table 5 presents the results, which are also depicted in Figure 3. The format is similar to the one used before, except that we are now looking at a series of portfolios with increasing short-sale constraint, so the numbers along the x-axis refer to the lowest RSI vicile in the

24

portfolio. Therefore, Portfolio 1, the left-most portfolio on the x-axis, contains all non-optioned firms in Viciles 1 through 20. Portfolio 2 contains Viciles 2 through 20. Portfolio 3 contains Viciles 3 through 20, and this pattern continues.

-0.80% Monthly Abnormal Return -0.85% -0.90% -0.95% -1.00% -1.05% -1.10% 1 2 3 4 5 6 7 8 9 10 11 12 13 Size of Smallest RSI Vicile in the Portfolio % Hedge Return P-Value

0.00 0.01 0.01 0.02 0.02 0.03 0.03 0.04 0.04 0.05 0.05

Figure 3: Hedge Portfolio Abnormal Returns and P-Values (I/B/E/S Dispersion) In Figure 3, we observe that the monthly hedge portfolio abnormal return for Portfolio 1 is -0.83% with a p-value better than 0.001. Thus, solely by restricting the analysis to firms with traded options, the result depicted in Figure 2 is reversed, and hedge portfolios constructed on the basis of dispersion of beliefs have negative returns. Although the p-values of these returns are already very high, restricting the sample to higher-RSI viciles makes the point estimate more negative, as we would expect. Miller Portfolio 13 in Figure 3 is a mirror image of Merton portfolio 12 in Figure 2. Portfolio 12 in Figure 2 is comprised of firms with traded options having RSI below the 13th vicile. Portfolio 13 in Figure 3 is comprised of firms without traded options having RSI greater than the 12th vicile. In the first case, short sale constraints are likely absent, and

P-Value

25

returns are an increasing function of idiosyncratic volatility. constraints are present and the relation is reversed.

In the second, short sale

Note that the results are not the same as those reported by Asquith and Meulbroek (1995) or Desai, Ramesh, Thiagarajan, and Balachandran (2002). These studies find that firms with high short interest earn low subsequent returns, but do not distinguish between high-dispersion-ofopinion firms and low-dispersion-of-opinion firms. By contrast, Figure 3 reveals that for nonoptioned firms, at any level of RSI, firms with higher dispersion-of-beliefs earn lower riskadjusted returns, and this relation becomes stronger at higher levels of RSI. Finally, we turn our attention to the effects of idiosyncratic volatility on returns when short-sale constraints are present. Because idiosyncratic volatility is positively correlated with I/B/E/S forecast dispersion, we expect to see hedge portfolio results similar to those observed in Figure 3 and Table 5.
0.00% -0.20% -0.40% -0.60% -0.80% -1.00% -1.20% -1.40% -1.60% -1.80% -2.00% 1 2 3 4 5 6 7 8 9 10 11 12 13 Size of Smallestt RSI Vicile in the Portfolio % Hedge Return P-Value 0.00 0.02 0.04 P-Value 0.06 0.08 0.10 0.12 0.14

Figure 4: Hedge Portfolio Abnormal Returns and P-Values (Idiosyncratic Risk) Figure 4 (numerically presented as Table 6) provides hedge portfolio returns for portfolios that hold long positions in high-idiosyncratic-volatility firms and short positions in lowidiosyncratic-volatility firms. The results are as expected. Portfolio 1 reflects all firms for 26

Monthly Abnormal Return

which options are not traded, and the abnormal returns for these firms are negative and economically significant, although they do not reflect statistical significance at standard levels. As the lowest RSI firms are removed from the sample, short-sale constraints rise, and the crosssectional effects of idiosyncratic volatility increases. Portfolio 13 reflects hedge portfolio monthly returns of -1.94% and statistical significance at p<0.001.

7. Summary and Conclusions


We examine the cross-sectional price effects of idiosyncratic risk and the related dispersion of beliefs. In the absence of short sale constraints, we find that expected returns are increasing in idiosyncratic risk, in accordance with Merton (1987). On the other hand, in the presence of short sale constraints, expected returns are decreasing in dispersion of opinion and idiosyncratic volatility, a result consistent with Miller (1977). These findings differ from prior research that almost universally tested Merton and Miller as competing hypotheses when they are, in fact, complementary. Of course, while Miller (1977) assumes absolute short-sale prohibitions and Merton (1987) assumes perfectly frictionless markets, short selling actually is neither frictionless nor prohibited. Instead, as has been described in a number of previous studies, short sales are usually relatively costly but not proscribed. Figure 5 would reflect a more proper juxtaposition of the predictions inferred from Merton (1987) and Miller (1977). When short-sale constraints are high, returns for firms with a high level of dispersion of beliefs will be abnormally low, consistent with Miller (1977). When short-sale constraints are absent, dispersion of beliefs produce discount prices so that returns will be abnormally high. At some points on the interior of the surface, the Merton effect will balance against the Miller effect. Our analysis has only roughly mapped the upper and lower edges of the surface in Figure 5. We have not attempted to describe the interior space or second derivatives of the curve. We 27

leave a full mapping of the space to future research. Our contributions are highlighting the complementary nature of the Merton and Miller theories, and to being the first to provide strong empirical support for Mertons (1987) model.

Figure 5:

Merton (1987) and Miller (1977) Represented as Complementary Hypotheses While Figure 5 details the effects of dispersion of beliefs, our tests also demonstrate why direct tests of idiosyncratic volatility as a risk factor produce mixed results. The presence or absence of short-sale constraints confounds the analysis. Idiosyncratic risk and dispersion of beliefs are highly correlated; perhaps both reflecting some underlying uncertainty level. Accordingly, abnormal returns, as a function of idiosyncratic volatility, also follow a pattern like that in Figure 5. If tests are conducted independent of short-sale-constraint proxies, the results will be weak, and may even be incorrectly signed. An interesting implication of our findings relates to the area of corporate governance. In Millers model, it may be argued that managers of short-sale-constrained firms can increase

28

share value by undertaking activities about which investors beliefs are highly heterogeneous. Absent short sale constraints, Merton suggests undertaking such projects would now induce discounts rather than premia in stock prices, and managers would be strongly motivated to reduce investor uncertainty concerning the firms prospects. When short-sale constraints are severe, the market may temporarily reward a lack of transparency by paying a premium for firms that create a smoke screen to obscure a firms financial position, but when short sale constraints are eliminated, the lack of transparency will itself be penalized with a discount. Thus, any policy aimed at reducing the cost of short selling could provide a significant social benefit if greater firm transparency is rewarded with higher share prices in a Merton environment rather than penalized with lower share values as in a Miller environment.

29

References Ackert, Lucy F. and George Athanassakos, 1997, Prior Uncertainty, Analyst Bias, and Subsequent Abnormal Returns, The Journal of Financial Research 20, 263-273. Ang, Andrew, Hodrick, Robert J., Xing, Yuhang and Zhang, Xiaoyan, 2004, The CrossSection of Volatility and Expected Returns, AFA 2005 Philadelphia Meetings, EFA 2004 Maastricht Meetings Paper No. 3057, http://ssrn.com/abstract=426460. Asquith, P. and L. Meulbroek, 1995, An Empirical Investigation of Short Interest, Working Paper, Harvard Business School. Asquith, Paul, Parag A. Pathak and Jay R. Ritter, 2005, Short Interest, Institutional Ownership, and Stock Returns, forthcoming Journal of Financial Economics Boehme, Rodney D. and Sorin M. Sorescu, 2002, The Long-Run Stock Performance Following Dividend Initiations and Resumptions: Underreaction or Product of Chance?, Journal of Finance 57, 871-900. Boehme, Rodney D. Bartley R. Danielsen and Sorin M. Sorescu, 2005, Short Sale Constraints, Dispersion of Opinion and Overvaluation, Journal of Financial and Quantitative Analysis, forthcoming. Brent, A., D. Morse, and E.K. Stice, 1990, Short Interest: Explanations and Tests, Journal of Financial and Quantitative Analysis 25, 273-289. Brown, Stephen and Jerold Warner, 1985, Using Daily Stock Returns: The Case of Event Studies, Journal of Financial Economics 14, 3-31. Carhart, Mark, 1997, On Persistence in Mutual Fund Performance, Journal of Finance 52, 57-82. Chen Joseph, Harrison Hong, Jeremy C. Stein, 2002, Breadth of Ownership and Stock Returns, Journal of Financial Economics 66: 171-205.

30

Cragg, John and Burton Malkiel, 1982, Expectations and the Structure of Share Prices (University of Chicago Press, Chicago, Il) Danielsen, Bartley R. and Sorin M. Sorescu, 2001, Why do Option Introductions Depress Stock Prices? A Study of Diminishing Short-Sale Constraints, Journal of Financial and Quantitative Analysis 36, 451-484. DAvolio, Gene, 2002, The Market for Borrowing Stock, Journal of Financial Economics 66, 271306. Dechow, Patricia M., A. P. Hutton, L. Meulbroek, and R. G. Sloan, 2001, Short-sellers, Fundamental Analysis and Stock Returns, Journal of Financial Economics 61, 77-106. Desai, Hemang, K. Ramesh, S. Ramu Thiagarajan and Bala V. Balachandran, 2002, An Investigation of the Informational Role of Short Interest in the Nasdaq Market, Journal of Finance 57, 2263-2287. Diamond, D.W. and R.E. Verrecchia, 1987, Constraints on Short-Selling and Asset Price Adjustment to Private Information, Journal of Financial Economics 18, 277-312. Diether, Karl B., Christopher J. Malloy and Anna Scherbina, 2002, Differences of Opinion and the Cross-Section of Stock Returns, Journal of Finance 57, 2113-2141. Duffie, Darrell, Nicolae Garleanu and Lasse Heje Pedersen, 2002, Securities Lending Shorting and Pricing, Journal of Financial Economics, 66, 307-339. Fama, Eugene and Kenneth French, 1993, Common Risk Factors in Returns on Stocks and Bonds, Journal of Financial Economics 33, 3-56. Fama, Eugene and Kenneth French, 1996, Multifactor Explanations of Asset Pricing Anomalies, Journal of Finance 51, 55-84. Fama, Eugene, 1998, Market Efficiency, Long-Term Returns and Behavioral Finance, Journal of Financial Economics 49, 283-306.

31

Fama, Eugene and Kenneth French, 2002, The Equity Premium, Journal of Finance 57, 637-659. Figlewski, S., 1981, The Informational Effects of Restrictions on Short Sales: Some Empirical Evidence, Journal of Financial and Quantitative Analysis 16, 463-476. Figlewski, S. and G.P. Webb, 1993, Options, Short Sales, and Market Completeness, Journal of Finance 48, 761-777. Garfinkel, Jon A. and Jonathon Sokobin, 2001, Rational Markets, Divergent Investor Opinions and Post-Earnings Announcement Drift, Working Paper, University of Iowa, August 2001. Geczy, Christopher C., David K. Musto and Adam V. Reed, 2002, Stocks Are Special Too: An Analysis of the Equity Lending Market, Journal of Financial Economics 66, 241-269. Harris, M. and A. Raviv, 1993, Differences of Opinion Make a Horse Race, Review of Financial Studies 6, 473-506. Hong, Harrison and Jeffrey D. Kubik, 2003, Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts, Journal of Finance 58, 313-351. Hong, Harrison and Jeremy Stein, 2002, Differences of Opinion, Short-Sale Constraints, and Market Crashes, Review of Financial Studies, forthcoming. Houge, T., T. Loughran, G. Suchanek, and X. Yan, 2001, Divergence of Opinion, Uncertainty, and the Quality of Initial Public Offerings , Financial Management 30, 5-23 . Jarrow, Robert, 1980, Heterogeneous Expectations, Restrictions on Short Sales, and Equilibrium Asset Prices, Journal of Finance 35, 1105-1113. Johnson, Timothy C., 2004, Forecast Dispersion and the Cross Section of Expected Returns, Journal of Finance 59, No. 5, 1957-1978. Jones, C.M., G. Kaul and M.L. Lipson, 1994, Transactions, Volume, and Volatility, Review of Financial Studies 7, 631-651.

32

Jones, C. M., and Owen A. Lamont, 2002, Short Sale Constraints and Stock Returns, Journal of Financial Economics 66, 207-239. Knight, Frank H., 1921, Risk, Uncertainty, and Profit, The Riverside Press, Cambridge, available at www.econlib.org/library/Knight/knRUP.html. Merton, Robert C., 1987, A Simple Model of Capital Market Equilibrium with Incomplete Information, Journal of Finance 42, 483-510 Miller, E.M., 1977, Risk, Uncertainty, and Divergence of Opinion, Journal of Finance 32, 1151-1168. Mitchell, Mark and Erik Stafford, 2000, Managerial Decisions and Long-Term Stock Price Performance, Journal of Business 73, 287-329. Morris, Stephen, 1996, Speculative Investor Behavior and Learning, The Quarterly Journal of Economics 111, 1111-1133. Peterson P.P. and D.R. Peterson, 1982, Divergence of Opinion and Return. Journal of Financial Research, 5, 125-134. Reed, Adam, 2002, Costly Short-Selling and Stock Price Adjustment to Earnings Announcements, Unpublished working paper, University of North Carolina at Chapel Hill. Shalen, C.T., 1993, Volume, Volatility, and the Dispersion of Beliefs, Review of Financial Studies 6, 405-434. Sorescu, Sorin, 2000, The Effect of Options on Stock Prices: 1973 to 1995, Journal of Finance 55, 487-514. Varian, Hal R., 1985, Divergence of Opinion in Complete Markets: A Note, The Journal of Finance 40, 309-317 Viswanathan, S., 2002, Strategic Trading, Heterogeneous Beliefs/Information, and Short Constraints, Unpublished working Paper, Duke University.

33

Welch, Ivo, 2000, Herding Among Security Analyst, Journal of Financial Economics 58, 369-396. Woolridge, J. R. and Amy Dickinson, 1994, Short Selling and Common Stock Prices, Financial Analysts Journal 50, 20-28

34

Table 1: Descriptive Statistics A description of each proxy variable is provided for different calendar dates (conditioned upon availability for the particular data series): January 1963, January 1968, January 1973, January 1978, January 1983, January 1988, January 1993, January 1998, and December 2002. Proxies are estimated for all U.S.-domiciled common stocks listed on the NYSE and Nasdaq. For each calendar date, the I/B/E/S Analyst Forecast Dispersion is the I/B/E/S standard deviation of earnings per share forecasts for the next fiscal year end. scaled by the forecast mean. The Idiosyncratic Risk (SIGMA) is the standard deviation of the error term obtained from the market model computed over the prior 100 days. The Relative Short Interest (RSI) is measured as the short interest divided by the number of outstanding shares. The OPTIONS status reports the total number of firms in our sample and the proportion of firms with exchange-traded options.
Dependent Variable Idiosyncratic Risk: SIGMA Date N. Obs. Mean First Percentile 0.0076 0.0080 0.0076 0.0042 0.0051 0.0094 0.0072 0.0010 0.0095 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 First Quartile 0.0128 0.0140 0.0130 0.0117 0.0173 0.0277 0.0216 0.0211 0.0208 0.0174 0.0296 0.0289 0.0194 0.0133 0.0095 0.0009 0.0006 0.0005 0.0013 Median Third Quartile 0.0205 0.0231 0.0226 0.0258 0.0383 0.0584 0.0577 0.0465 0.0547 0.0593 0.1474 0.1556 0.1059 0.0756 0.0660 0.0071 0.0086 0.0163 0.0213 99th Percentile 0.0415 0.0396 0.0452 0.0791 0.1160 0.4983 0.2104 0.1506 0.1608 0.4059 4.6667 5.0000 3.1000 2.2143 2.6667 0.0981 0.1236 0.1605 0.2333

196301 196801 197301 197801 198301 198801 199301 199801 200212 197801 198301 198801 199301 199801 200212 198801 199301 199801 200212 198801 199301 199801 200212

1130 1183 1376 3623 4097 5437 5027 6547 4677 897 1619 2153 2506 3867 2566 1145 4166 6111 4413 5478 5068 6665 4809

0.0175 0.0193 0.0187 0.0210 0.0313 0.0468 0.0471 0.0389 0.0428 0.0621 1.6254 1.6912 1.3904 1.6841 4.4104 0.0083 0.0105 0.0157 0.0266 0.0785 0.1689 0.2825 0.4999

0.0162 0.0180 0.0171 0.0172 0.0256 0.0407 0.0355 0.0317 0.0330 0.0327 0.0581 0.0593 0.0417 0.0290 0.0233 0.0026 0.0023 0.0038 0.0096

I/B/E/S analyst earnings forecast dispersion: DISPERSION

Relative Short Interest (%): RSI OPTIONS: Percent of Firms with Exchange Traded Options

35

Table 2: Unconditional Abnormal Returns as a Function of Idiosyncratic Risk and Analyst Forecast Dispersion Calendar time portfolio (one and twelve month horizons) abnormal returns are shown as a function of idiosyncratic risk (SIGMA) and analyst earnings forecast dispersion (DISPERSION) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms. SIGMA is the standard deviation of the error term obtained from the Brown and Warner (1985) market model regression computed over the prior 100 days of stock returns. SIGMA quartiles are assigned for each month, beginning with January 1963 and ending with December 2002) by sorting all NYSE and Nasdaq firms on the SIGMA. DISPERSION is measured by dividing the I/B/E/S standard deviation of analyst earnings/share forecasts for the current fiscal year end (I/B/E/S FY period 1) by the absolute value of the mean earnings/share forecast, as listed in the I/B/E/S Summary History file. Observations having a mean earnings forecast of zero are omitted for the purpose of assigning the rank ordering of firms. DISPERSION quartiles are assigned for each month (beginning with January 1976) by sorting all NYSE and Nasdaq firms on the DISPERSION. Firms having a mean forecast of zero are then assigned to the highest DISPERSION quartile. Quartiles 1 and 4 are the lowest and highest SIGMA and DISPERSION quartiles, respectively. The abnormal returns are computed by forming equally-weighted calendar-time portfolios of either one month or twelve month horizons and regressing the excess portfolio returns (Rp,t-Rf,t) on a four factor model: the three Fama and French (1993) risk factors (Rm-Rf, SMB, HML) and the momentum factor of Carhart (1997) (UMD). Calendar time portfolios are re-balanced each month, and include only firms that entered the portfolio during either the prior month or previous twelve months. The estimation method is weighted least squares; monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the following regression: Rp,t-Rf,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. We also report the long-term abnormal return of a hedge (or zero-investment) portfolio, consisting of long positions of stocks with the highest SIGMA or DISPERSION quartile and short positions of stocks in the lowest SIGMA or DISPERSION quartile. The abnormal return to the hedge portfolio is computed as the intercept (p) from the following regression: Rhigh-sigma,t-Rlow-sigma,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. Results are presented in Panel A below are for the February 1988 to December 2002 period, and results presented in Panels B and C begin with January 1963 for SIGMA and February 1976 for DISPERSION and end with December 2002. An abnormal return of 0.00187 below is to be interpreted as an abnormal return of 0.187 percent per calendar month. p-values reporting statistical difference from zero are shown in the rightmost column for the hedge portfolio intercept and are computed from the intertemporal variation in the monthly calendar-time portfolio returns. Panel A: Idiosyncratic risk (SIGMA) and Analyst earnings forecast dispersion (DISPERSION), February 1988 through December 2002

Independent Variable and Portfolio Horizon

1st quartile (lowest)

2nd quartile

3rd quartile

4th quartile (highest)

Hedge portfolio: 4th quartile minus 1st quartile -0.00159 0.00192 -0.00462 -0.00163

p-value of hedge portfolio

SIGMA, 1-month SIGMA, 12-month DISPERSION, 1-month DISPERSION, 12-month

0.00187 0.00169 0.00240 0.00167

0.00241 0.00115 0.00165 0.00143

-0.00068 -0.00025 0.00081 0.00112

0.00029 0.00357 -0.00233 0.00004

0.7284 0.6720 0.0370 0.4509

36

Panel B: Idiosyncratic risk (SIGMA), January 1963 through December 2002 SIGMA 1st quartile (lowest) Calendar time portfolio horizon 1-month 12-month 0.00178 0.00182 0.00230 0.00125 0.00036 0.00046 -0.00090 0.00163 2nd quartile 3rd quartile 4th quartile (highest) Hedge portfolio: 4th quartile minus 1st quartile -0.00268 -0.00014 p-value of hedge portfolio

0.2571 0.9513

Panel C: Analyst earnings forecast dispersion (DISPERSION), February 1976 through December 2002 DISPERSION 1st quartile (lowest) Calendar time portfolio horizon 1-month 12-month 0.00275 0.00200 0.00228 0.00182 0.00138 0.00144 -0.00203 -0.00006 2nd quartile 3rd quartile 4th quartile (highest) Hedge portfolio: 4th quartile minus 1st quartile -0.00478 -0.00205 p-value of hedge portfolio

0.0025 0.1759

37

Table 3: A Test of Mertons Hypothesis: Abnormal Returns as a Function of Idiosyncratic Risk, Conditioned on Absence of Short Sale Constraints One-month calendar time abnormal returns are shown as a function of idiosyncratic risk (SIGMA) and Relative Short Interest (RSI) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms having exchange traded options. SIGMA is measured as the standard deviation of the error term obtained from the Brown and Warner (1985) market model regression computed over the prior 100 days of stock returns. SIGMA quartiles are assigned for each month, beginning with February 1988 and ending with December 2002) by sorting all NYSE and Nasdaq firms on the SIGMA. Quartiles 1 and 4 are the lowest and highest SIGMA quartiles, respectively. The analysis below begins by first examining firms in RSI viciles 1 through 20, and then proceeds by progressively deleting firms in the higher RSI viciles. The abnormal returns are computed by forming equally-weighted calendar-time portfolios of one month horizon and regressing the excess portfolio returns (Rp,t-Rf,t) on a four factor model: the three Fama and French (1993) risk factors (RmRf, SMB, HML) and the momentum factor of Carhart (1997) (UMD). Calendar time portfolios are re-balanced each month, and include only firms that entered the portfolio during the prior month. The estimation method is weighted least squares; monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the following regression: Rp,t-Rf,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. We also report the long-term abnormal return of a hedge (or zero-investment) portfolio, consisting of long positions of stocks with the highest SIGMA quartile and short positions of stocks in the lowest SIGMA quartile. The abnormal return to the hedge portfolio is computed as the intercept (p) from the following regression: Rhigh-sigma,t-Rlow-sigma,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. Results are presented for the February 1988 to December 2002 period. An abnormal return of 0.00056 below is to be interpreted as an abnormal return of 0.056 percent per calendar month. p-values reporting statistical difference from zero are shown in the rightmost column for the hedge portfolio intercept and are computed from the intertemporal variation in the monthly calendar-time portfolio returns. SIGMA Option Status Largest RSI in portfolio 1st quartile (lowest) 2nd quartile 3rd quartile 4th quartile (highest) Hedge portfolio: 4th quartile minus 1st quartile -0.00002 0.00332 0.00612 0.00841 0.00964 0.01067 0.01218 0.01417 0.01420 p-value of hedge portfolio

20 19 18 17 Optioned 16 15 14 13 12

0.00056 0.00061 0.00078 0.00095 0.00108 0.00104 0.00108 0.00103 0.00125

0.00095 0.00153 0.00170 0.00216 0.00254 0.00245 0.00285 0.00332 0.00392

-0.00083 0.00139 0.00248 0.00423 0.00523 0.00563 0.00598 0.00519 0.00577

0.00320 0.00624 0.00935 0.01131 0.01274 0.01369 0.01516 0.01696 0.01772

0.4986 0.2731 0.1458 0.0897 0.0625 0.0490 0.0326 0.0189 0.0240

38

Table 4: An Alternative Test of Mertons Hypothesis: Abnormal Returns as a Function of Forecast Dispersion, Conditioned on the Absence of Short Sale Constraints One-month calendar time abnormal returns are shown as a function of I/B/E/S analyst earnings forecast dispersion (DISPERSION) and Relative Short Interest (RSI) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms having exchange traded options. DISPERSION is measured by dividing the I/B/E/S standard deviation of analyst earnings/share forecasts for the current fiscal year end (I/B/E/S FY period 1) by the absolute value of the mean earnings/share forecast, as listed in the I/B/E/S Summary History file. Observations having a mean earnings forecast of zero are omitted for the purpose of assigning the rank ordering of firms. DISPERSION quartiles are assigned for each month by sorting all NYSE and Nasdaq firms on the DISPERSION. Firms having a mean forecast of zero are then assigned to the highest DISPERSION quartile. Quartiles 1 and 4 are the lowest and highest DISPERSION quartiles, respectively. The analysis below begins by first examining firms in RSI viciles 1 through 20, and then proceeds by progressively deleting firms in the higher RSI viciles. The abnormal returns are computed by forming equally-weighted calendar-time portfolios of one month horizon and regressing the excess portfolio returns (Rp,t-Rf,t) on a four factor model: the three Fama and French (1993) risk factors (RmRf, SMB, HML) and the momentum factor of Carhart (1997) (UMD). Calendar time portfolios are re-balanced each month, and include only firms that entered the portfolio during the prior month. The estimation method is weighted least squares; monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the following regression: Rp,t-Rf,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. We also report the long-term abnormal return of a hedge (or zero-investment) portfolio, consisting of long positions of stocks with the highest DISPERSION quartile and short positions of stocks in the lowest DISPERSION quartile. The abnormal return to the hedge portfolio is computed as the intercept (p) from the following regression: Rhigh-sigma,t-Rlow-sigma,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. Results are presented for the February 1988 to December 2002 period. An abnormal return of 0.00062 below is to be interpreted as an abnormal return of 0.062 percent per calendar month. p-values reporting statistical difference from zero are shown in the rightmost column for the hedge portfolio intercept and are computed from the intertemporal variation in the monthly calendar-time portfolio returns. DISPERSION Option Status Largest RSI in portfolio 1st quartile (lowest) 2nd quartile 3rd quartile 4th quartile (highest) Hedge portfolio: 4th quartile minus 1st quartile
0.00139 0.00186 0.00299 0.00327 0.00311 0.00307 0.00409 0.00408 0.00511

p-value of hedge portfolio

20 19 18 17 Optioned 16 15 14 13 12

0.00062 0.00119 0.00124 0.00186 0.00211 0.00202 0.00174 0.00194 0.00185

0.00122 0.00227 0.00272 0.00271 0.00315 0.00349 0.00415 0.00466 0.00514

0.00133 0.00227 0.00263 0.00338 0.00380 0.00410 0.00472 0.00410 0.00451

0.00209 0.00318 0.00434 0.00523 0.00527 0.00523 0.00604 0.00627 0.00731

0.2973 0.2351 0.1212 0.1050 0.1154 0.1272 0.0714 0.0867 0.0544

39

Table 5: A Test of Millers Hypothesis: Abnormal Returns as a Function of Forecast Dispersion, Conditioned on the Presence of Short Sale Constraints One-month calendar time abnormal returns are shown as a function of I/B/E/S analyst earnings forecast dispersion (DISPERSION) and Relative Short Interest (RSI) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms that do not have exchange traded options. DISPERSION is measured by dividing the I/B/E/S standard deviation of analyst earnings/share forecasts for the current fiscal year end (I/B/E/S FY period 1) by the absolute value of the mean earnings/share forecast, as listed in the I/B/E/S Summary History file. Observations having a mean earnings forecast of zero are omitted for the purpose of assigning the rank ordering of firms. DISPERSION quartiles are assigned for each month by sorting all NYSE and Nasdaq firms on the DISPERSION. Firms having a mean forecast of zero are then assigned to the highest DISPERSION quartile. Quartiles 1 and 4 are the lowest and highest DISPERSION quartiles, respectively. The analysis below begins by first examining firms in RSI viciles 1 through 20, and then proceeds by progressively deleting firms in the smaller RSI viciles. The abnormal returns are computed by forming equally-weighted calendar-time portfolios of one month horizon and regressing the excess portfolio returns (Rp,t-Rf,t) on a four factor model: the three Fama and French (1993) risk factors (Rm-Rf, SMB, HML) and the momentum factor of Carhart (1997) (UMD). Calendar time portfolios are re-balanced each month, and include only firms that entered the portfolio during the prior month. The estimation method is weighted least squares; monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the following regression: Rp,t-Rf,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. We also report the long-term abnormal return of a hedge (or zero-investment) portfolio, consisting of long positions of stocks with the highest DISPERSION quartile and short positions of stocks in the lowest DISPERSION quartile. The abnormal return to the hedge portfolio is computed as the intercept (p) from the following regression: Rhigh-sigma,t-Rlow-sigma,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. Results are presented for the February 1988 to December 2002 period. An abnormal return of 0.00330 below is to be interpreted as an abnormal return of 0.330 percent per calendar month. p-values reporting statistical difference from zero are shown in the rightmost column for the hedge portfolio intercept and are computed from the intertemporal variation in the monthly calendar-time portfolio returns. DISPERSION Option Status Smallest RSI in portfolio
1 2 3 4 5 Non optioned 6 7 8 9 10 11 12 13

1 quartile (lowest)
0.00330 0.00315 0.00294 0.00273 0.00253 0.00228 0.00196 0.00158 0.00129 0.00098 0.00060 0.00018 0.00009

st

2 quartile

nd

3rd quartile

4th quartile (highest)


-0.00512 -0.00542 -0.00575 -0.00607 -0.00646 -0.00683 -0.00681 -0.00728 -0.00772 -0.00826 -0.00871 -0.00941 -0.01023

Hedge portfolio: 4th minus 1st quartile


-0.00831 -0.00843 -0.00853 -0.00862 -0.00884 -0.00898 -0.00861 -0.00868 -0.00885 -0.00914 -0.00916 -0.00953 -0.01034

p-value of hedge portfolio


0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0001 0.0001 0.0000 0.0001 0.0000 0.0000

0.00187 0.00182 0.00166 0.00142 0.00136 0.00114 0.00067 0.00022 0.00012 -0.00015 -0.00034 -0.00041 -0.00066

-0.00043 -0.00057 -0.00071 -0.00101 -0.00107 -0.00139 -0.00170 -0.00205 -0.00224 -0.00238 -0.00266 -0.00288 -0.00289

40

Table 6: An Alternative Test of Millers Hypothesis: Abnormal Returns as a Function of Idiosyncratic Risk, Conditioned on the Presence of Short Sale Constraints One-month calendar time abnormal returns are shown as a function of idiosyncratic risk (SIGMA) and Relative Short Interest (RSI) for all CRSP listed common stocks (CRSP share codes 10 and 11) of U.S. domiciled NYSE and Nasdaq firms that do not have exchange traded options. SIGMA is measured as the standard deviation of the error term obtained from the Brown and Warner (1985) market model regression computed over the prior 100 days of stock returns. SIGMA quartiles are assigned for each month, beginning with February 1988 and ending with December 2002) by sorting all NYSE and Nasdaq firms on the SIGMA. Quartiles 1 and 4 are the lowest and highest SIGMA quartiles, respectively. The analysis below begins by first examining firms in RSI viciles 1 through 20, and then proceeds by progressively deleting firms in the smaller RSI viciles. The abnormal returns are computed by forming equally-weighted calendar-time portfolios of one month horizon and regressing the excess portfolio returns (Rp,t-Rf,t) on a four factor model: the three Fama and French (1993) risk factors (Rm-Rf, SMB, HML) and the momentum factor of Carhart (1997) (UMD). Calendar time portfolios are re-balanced each month, and include only firms that entered the portfolio during the prior month. The estimation method is weighted least squares; monthly excess returns are weighted by the square root of the number of firms in each month. The abnormal return for each sub-sample is the intercept (p) from the following regression: Rp,t-Rf,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. We also report the long-term abnormal return of a hedge (or zero-investment) portfolio, consisting of long positions of stocks with the highest SIGMA quartile and short positions of stocks in the lowest SIGMA quartile. The abnormal return to the hedge portfolio is computed as the intercept (p) from the following regression: Rhigh-sigma,t-Rlow-sigma,t = p + p(Rm,t-Rf,t) + spSMBt + hpHMLt + upUMDt + ep,t. Results are presented for the February 1988 to December 2002 period. An abnormal return of 0.00322 below is to be interpreted as an abnormal return of 0.322 percent per calendar month. p-values reporting statistical difference from zero for the hedge portfolio intercept are computed from the intertemporal variation in the monthly calendar-time portfolio returns. SIGMA Option Status Smallest RSI in portfolio 1 2 3 4 5 Non optioned 6 7 8 9 10 11 12 13 1st quartile (lowest) 0.00322 0.00313 0.00299 0.00279 0.00259 0.00236 0.00205 0.00169 0.00145 0.00125 0.00118 0.00133 0.00114 2nd quartile 3rd quartile 4th quartile (highest) -0.00252 -0.00335 -0.00429 -0.00520 -0.00616 -0.00706 -0.00836 -0.00940 -0.01069 -0.01252 -0.01411 -0.01658 -0.01807 Hedge portfolio: 4th minus 1st quartile -0.00580 -0.00655 -0.00738 -0.00814 -0.00888 -0.00963 -0.01067 -0.01143 -0.01250 -0.01404 -0.01559 -0.01814 -0.01939 p-value of hedge portfolio 0.1021 0.0784 0.0572 0.0424 0.0305 0.0223 0.0130 0.0089 0.0046 0.0017 0.0006 0.0001 0.0000

0.00263 0.00248 0.00214 0.00184 0.00158 0.00122 0.00099 0.00047 0.00015 -0.00052 -0.00109 -0.00114 -0.00136

-0.00174 -0.00203 -0.00239 -0.00277 -0.00317 -0.00368 -0.00429 -0.00507 -0.00561 -0.00626 -0.00667 -0.00769 -0.00824

41