Two Essays on the Cross-Section of Stock Returns

DISSERTATION

Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy
in the Graduate School of The Ohio State University

By

Peter Wong

Graduate Program in Business Administration

The Ohio State University

2013

Dissertation Committee:

Prof. Kewei Hou, Advisor

Prof. René M. Stulz

Prof. Ingrid M. Werner

Prof. Lu Zhang
© Copyrighted by

Peter Wong

2013
 Abstract

This dissertation studies two distinct topics. First, I examine whether the idiosyncratic

volatility discount anomaly documented by Ang, Hodrick, Xing, and Zhang (2006, 2009)

is related to earnings shocks, and I find that a substantial portion of the idiosyncratic

volatility discount can be explained by earnings momentum and post-formation earnings

shocks. When these two effects are accounted for, idiosyncratic volatility has little, if

any, return predictability.

Second, I propose a parsimonious measure to characterize the severity of the

microstructure noise at the individual stock level and assess the impact of this

microstructure induced illiquidity on cross-sectional return predictability. One of the

main advantages of this measure is that it is very simple to construct (requires only daily

stock returns data). Using this measure I find that firms with the largest microstructure

bias command a return premium as large as 9.61% per year, even after controlling for the

premiums associated with size, book-to-market, momentum, and traditional liquidity

price impact and cost measures. In addition, the bias premium is strongest among small,

low price, volatile, and illiquid stocks. On the other hand, the premiums associated with

size, illiquidity, and return reversal are most pronounced among stocks with the largest

bias.

ii
 Dedication

My dissertation is dedicated to my friend and advisor, Kewei Hou, who has been a

great source of motivation and inspiration. Also, this thesis is dedicated to my parents,

my two sisters, Debra, and my brother-in-law (Jacky Lee) who have supported me all the

way since the beginning of my studies. To all my friends who listened and shared my

concerns, I will forever be grateful.

iii
 Acknowledgments

I am deeply indebted to my advisor, Kewei Hou, for his support, encouragements,

and insightful comments that made this dissertation possible. He has been my role model

and a great source of inspiration, and I would never have made it to this stage of the

program without his help.

I would also like to thank my dissertation committee members, Professor René Stulz,

Professor Ingrid Werner, and Professor Lu Zhang for their guidance, patients, and

assistance throughout the process of job market and my dissertation. My second essay in

the dissertation is coauthored with Professor Kewei Hou and Professor Ingrid Werner.

I would like to acknowledge my fellow PhD students, especially Robert Prilmeier,

Tom Xie, Jia Chen, and John Sedunov for all of your help and advice throughout the

program.

Lastly, I would also like to acknowledge the Dice Center for research support and

seminar participants at The Ohio State University, University of South Carolina,

University of Delaware, Cornerstone Research (New York), Norwegian School of

Economics (NHH), University of Warwick, University of Hong Kong, City University of

Hong Kong, George Mason University, and Cornell University for helpful comments.

iv
 Vita

2003................................................................St. Andrew’s College (Aurora, Canada)

2003-2007 ......................................................B.Com, University of Toronto

2012 - Present ...............................................Assistant Professor of Finance

University of South Carolina
Columbia, SC

Fields of Study

Major Field: Business Administration

v
 Table of Contents

Abstract ............................................................................................................................... ii

Dedication .......................................................................................................................... iii

Acknowledgments.............................................................................................................. iv

Vita...................................................................................................................................... v

Table of Contents ............................................................................................................... vi

List of Tables ..................................................................................................................... ix

List of Figures ..................................................................................................................... x

Chapter 1: Earnings Shocks and the Idiosyncratic Volatility Anomaly in the Cross-

Section of Stock Returns ..................................................................................................... 1

1.1 Introduction .......................................................................................................... 1

1.2 Data and measurements ........................................................................................ 7

1.3 Idiosyncratic volatility and earnings shocks ........................................................ 8

1.4 Earnings momentum and the IVOL discount ..................................................... 18

1.4.1 Double-sorting on SUE and IVOL ............................................................. 19

1.4.2 Momentum factor and the IVOL discount .................................................. 22

vi
 1.4.3 Combining double-sorting and the earnings momentum factor ................. 23

1.5 Post-formation earnings shocks and the IVOL discount .................................... 26

1.5.1 Adjusting realized returns with post-formation earnings shocks ................ 26

1.5.2 Implied cost of capital and the IVOL discount ........................................... 29

1.6 Earnings momentum effect and post-formation earnings shocks ...................... 38

1.7 Fama-MacBeth cross-sectional regressions ....................................................... 41

1.8 Conclusion.......................................................................................................... 49

Chapter 2: Microstructure Bias, Illiquidity, and the Cross-Section of Expected Stock

Returns .............................................................................................................................. 51

2.1 Introduction ........................................................................................................ 51

2.2 Simple model...................................................................................................... 56

2.3 Data and the construction of bias measure ......................................................... 59

2.4 Characteristics of bias-sorted portfolios ............................................................. 62

2.5 Microstructure bias and the cross-section of expected returns .......................... 67

2.5.1 Bias measure constructed using past 1-year daily returns .......................... 71

2.5.2 Alternative measures of microstructure bias............................................... 74

2.5.3 Sub-samples ................................................................................................ 74

vii
 2.5.4 Sub-periods ................................................................................................. 75

2.5.5 Further return adjustment ............................................................................ 75

2.6 Fama-MacBeth cross-sectional regressions ....................................................... 76

2.7 Interaction of bias with firm characteristics ....................................................... 81

2.7.1 Bias premium across characteristics quintiles ............................................ 81

2.7.2 Characteristics premiums across bias quintiles........................................... 85

2.8 Extension: Using data from the United Kingdom .............................................. 88

2.9 Conclusion.......................................................................................................... 91

References ......................................................................................................................... 93

viii
 List of Tables

Table 1.1. Characteristics of IVOL-sorted portfolios………………………………….....9

Table 1.2. Earnings surprises of IVOL-sorted portfolios………………………………..13

Table 1.3. Interaction between earnings momentum and the IVOL discount…………...20

Table 1.4. Combination of the two approaches to control for the earnings momentum…25

Table 1.5. Returns adjusted for post-formation earnings shocks………………………...28

Table 1.6. Earnings forecast and implied cost of capital…………………………….......34

Table 1.7. Combination of all adjustments………………………………………………39

Table 1.8. Fama-MacBeth regressions…………………………………………………...42

Table 2.1. Characteristics of bias-sorted portfolios……………………………………...64

Table 2.2. Microstructure bias and the cross-section of expected stock returns…............72

Table 2.3. Fama-MacBeth regressions…………………………………………………...77

Table 2.4. Bias premium across characteristic quintiles…………………………………82

Table 2.5. Characteristics premium across bias quintiles………………………………..86

Table 2.6. Illiquidity of stocks listed on major exchanges in United Kingdom…………89

ix
 List of Figures

Figure 1.1. Earnings Shocks of IVOL-sorted portfolios……………………………........11

Figure 1.2. Timeline of earnings forecasts and ICC estimation…....................................32

Figure 2.1. Historical Bias estimates based on CRSP data……………………………....69

x
Chapter 1: Earnings Shocks and the Idiosyncratic Volatility Anomaly in the Cross-
Section of Stock Returns

1.1 Introduction

In a recent paper, Ang, Hodrick, Xing, and Zhang (2006) find that high idiosyncratic

volatility (IVOL) stocks earn lower returns than low IVOL stocks by approximately 1%

per month. They refer to this underperformance as the IVOL discount. This finding is

robust and has since been confirmed in numerous papers.1 The empirical fact that high

IVOL stocks have lower returns is inconsistent with traditional asset pricing theories

based on a complete market in which investors are well diversified, and do not demand

either a premium or a discount for holding high IVOL stocks. If, on the other hand,

investors demand compensation for being unable to diversify risk,2 then they will demand

a premium, not a discount, for holding high IVOL stocks. In particular, Merton (1987)

suggests that in an information-segmented market, investors require higher returns for

firms with larger firm-specific variances to compensate them for holding imperfectly

diversified portfolios. Some behavioral models, like Barberis and Huang (2001), also

predict higher IVOL stocks should earn higher expected returns. Thus, it is difficult to

1
For example, see Ang et al. (2009), Fu (2009), and Bali, Cakici, and Whitelaw (2011).
2
See Malkiel and Xu (2002) and Jones and Rhodes-Kropf (2003).
1
reconcile Ang et al.’s (2006) result with existing theories linking IVOL to expected

returns. Even though the magnitude and statistical significance of the return spread

between high and low IVOL stocks seem beyond doubt, an important question has yet to

be addressed: What differences in the economic fundamentals between these stocks are

driving this return spread? The goal of this paper is to fill this knowledge gap.

Specifically, I study whether the behavior of stock returns in relation to IVOL is

consistent with the behavior of earnings. As earnings serve as perhaps the most important

economic signal for investors in terms of valuing shares, an exploration of the difference

in earnings performance is a natural starting point in an attempt to explain the IVOL

discount. In addition, previous literature3 studies whether the behavior of stock prices in

relation to firm characteristics such as size, book-to-market-equity, and past return can be

explained by differences in earnings performance. Therefore, my approach of

investigating the relation between IVOL and earnings performance is consistent with

what has been done in the literature.

My study is further motivated by Ang et al.’s (2006) finding that firms with high

IVOL stocks tend to be value firms and that they are typically small, young, and past

return losers. Previous research shows that firms with these characteristics typically have

poor earnings performance. For example, Fama and French (1995) document that small-

value firms tend to have the worst earnings performance of all stocks. In addition, Fama

and French (2004) report that, starting in 1980s, newly listed firms (especially those that

are small) perform badly. Consistent with this evidence, Hou and Van Dijk (2012) find

3
See Fama and French (1995), La Porta, Lakonishok, Shleifer, and Vishny (1997), and Chan, Jegadeesh,
and Lakonishok (1996).
2
that small firms experience large negative profitability shocks (post-formation earnings

shocks) after the 1980s. Lastly, Chan et al. (1996) and Chordia and Shivakumar (2006)

demonstrate that price momentum losers tend to have negative earnings shocks prior to

portfolio formation, and that these negative earnings shocks continue for up to four

quarters after portfolio formation. Therefore, it is possible that the large IVOL discount is

a result of the difference in earnings performance between the high and low IVOL stocks.

In this paper, I find that high IVOL stocks suffer negative earnings shocks both

before and after portfolio formation. To gauge the magnitude of the difference in earnings

shocks between the high and low IVOL firms, I compute average standardized

unexpected earnings (SUE) for each quintile of stocks sorted by IVOL (value weighted).

The difference in the SUE between the highest and the lowest IVOL quintile portfolios

right before portfolio formation is -1.16 with a Newey-West (1987) t-statistic of -20.85.

This difference in earnings shocks persists for at least two quarters after portfolio

formation. The SUE spreads between the highest and the lowest IVOL quintiles around

the first and second quarterly earnings announcements after portfolio formation are -1.33

(t = -23.85) and -1.08 (t = -21.34), respectively. Since an extensive literature shows that

firms reporting unexpectedly high earnings outperform firms reporting unexpectedly poor

earnings after the earnings announcement4 (the “earnings momentum effect”), I then

relate the IVOL discount to the earnings momentum effect associated with the pre-

formation earnings shocks. In addition, Hou and Van Dijk (2012) and Vuolteenaho

(2002) demonstrate the importance of post-formation earnings shocks in explaining

4
For example, see Latane and Jones (1979), Bernard and Thomas (1989), and Bernard, Thomas, and
Wahlen (1997).
3
realized stock returns. As high IVOL stocks tend to experience large negative earnings

shocks after portfolio formation, I also investigate the importance of post-formation

earnings shocks in explaining the IVOL discount.

To assess the impact of the earnings momentum effect on the IVOL discount, I

double sort stocks into 5x5 portfolios based on their most recent SUEs and IVOLs. The

results of this double-sorting exercise show that controlling for the earnings momentum

effect reduces the IVOL discount from -1.11% to -0.63% per month. In addition, I follow

Chordia and Shivakumar (2006) in forming the earnings momentum factor (PMN) and

use this factor along with the Fama and French (1993) three-factor (FF3F) model to

compute the abnormal returns of the IVOL portfolios. The results derived from using the

PMN factor to control for the earnings momentum effect is largely consistent with those

obtained in the double-sorting exercise. Specifically, the PMN factor reduces the IVOL

discount from -1.11% to -0.66% (41% reduction in IVOL discount). Lastly, to ensure that

the earnings momentum effect has been adequately accounted for, I use both the double-

sort method and PMN factor adjustment at the same time. This procedure essentially

combines the first and second approaches to control for the earnings momentum effect,

and it reduces the IVOL discount from -1.11% to -0.29%. Thus, the evidence is

consistent with the argument that the earnings momentum effect associated with pre-

formation earnings shocks is important in explaining the IVOL discount. The results from

the cross-section Fama-MacBeth (1973) test reach a similar conclusion.

As noted before, high IVOL firms continue to experience negative earnings shocks

after portfolio formation. Thus, I also investigate the possibility that the large negative

4
return spread between the high and low IVOL firms is partly due to differences in post-

formation earnings shocks. To this end, I adjust monthly stock returns by removing the

daily returns surrounding post-formation earnings announcements. Consistent with my

conjecture, I find that post-formation earnings shocks also explain part of the IVOL

discount. Specifically, the removal of three-day returns surrounding post-formation

earnings announcements reduces the IVOL discount from -1.11% to -0.83%. This is a

sizable reduction considering that there are 22 trading days per month and only one-

fourth of the firms in the sample announce earnings in a given month. In addition, I show

that post-formation earnings shocks still capture approximately 20% of the IVOL

discount even after controlling for the earnings momentum effect associated with pre-

formation earnings shocks. Consistent with the post-formation earnings shocks

explanation, using implied cost of capital (ICC), a proxy for ex-ante expected stock

returns, I do not observe a negative relation between ICC and IVOL. In fact, ICCs of high

IVOL stocks are 0.23% to 0.38% higher than that of low IVOL stocks. Lastly, the

combined effect of (both pre-formation and post-formation) earnings shocks can explain

up to 91% of the IVOL discount.

This paper contributes to the ongoing debate on the sources of the IVOL discount. In

particular, one group of explanations attributes the IVOL discount to specific firm-level

events and measurements. For instance, Johnson (2004) argues uncertainty is negatively

related to future returns because equity is a call option on a levered firm’s underlying

assets, while Avramov, Chordia, Jostova, and Philipov (2012) finds that the IVOL puzzle

only exists among financially distressed firms. Furthermore, Fu (2009) and Chen and

5
Petkova (2012) suggest that the IVOL discount can be captured using a more carefully

constructed volatility measure ,and lastly, Jiang, Xu, and Yao (2009) and George and

Hwang (2010) suggest the IVOL discount is related to important corporate events, such

as earnings news.

This paper contributes to the literature by showing that the IVOL discount arises

because high IVOL stocks experience negative earnings shocks prior to portfolio

formation, and that the earnings momentum effect induces the low returns observed in

these stocks. In addition, high IVOL stocks continue to surprise investors with poor

earnings performance after portfolio formation. These post-formation negative earnings

shocks further adversely affect high IVOL stocks’ returns.

The remainder of the paper is organized as follows. Section 1.2 introduces the data,

the measurement of IVOL and earnings surprises, and the adjustment of stock returns to

reflect post-formation earnings shocks. Section 1.3 introduces the summary statistics for

the sample, and demonstrates that high IVOL stocks experience negative earnings shocks

before and after portfolio formation. Sections 1.4 and 1.5 present the time-series tests of

how the IVOL discount is affected by earnings momentum and post-formation earnings

shocks, respectively. Section 1.6 quantifies the combined effect of earnings momentum

and post-formation earnings shocks on the IVOL discount. Section 1.7 examines the

results using Fama-MacBeth regressions and section 1.8 concludes.

6
1.2 Data and measurements

I obtain stock price data for all publicly traded firms on NYSE/AMEX/Nasdaq with

sharecodes 10 or 11 (e.g., excluding ADRs, closed-end funds, and REITs) from the

Center for Research in Security Prices’ (CRSP) monthly file for the period beginning

January 1972 and ending December 2008. Consensus analyst forecasts and the

corresponding actual earnings are obtained from the I/B/E/S summary files. I also obtain

the following accounting data from COMPUSTAT. Book equity (BE) is the

stockholders’ equity plus the deferred tax and investment credit on the balance sheet

minus the book value of preferred stock. The book-to-market ratio is calculated by

dividing book equity by December t-1 market equity. To ensure that the book equity

information was known before the return series against which it is measured, I match

CRSP monthly returns between July of year t and June of year t+1 with book equity for

the fiscal year ending in year t-1, as in Fama and French (1992). I do not include

negative-BE firms. Firm age is defined as the number of years a firm has return data

available from CRSP.

I follow Ang et al. (2006) in computing IVOL for each firm using daily returns from

the prior month, and I regress them on the Fama and French (1993) three-factor model

(FF3F). IVOL is the standard deviation of the model’s residuals. Firms with less than 15

observations in fitting the FF3F model are removed from my final sample.

I compute three measures of earnings surprises: SUE, SUE1, and CAR. SUE is

defined as earnings in the current quarter less earnings four quarters ago and is

standardized by the standard deviation of the earnings changes over the prior eight
7
quarters. SUE1 is defined in manner similar to SUE except it is standardized by the share

price four quarters ago. CAR is the three-day, cumulative, (value-weighted) market-

adjusted returns from one day prior to an earnings announcement to one day after that

announcement.5

I also follow Chordia and Shivakumar (2006) in forming an earnings momentum

factor, PMN factor, to capture the earnings momentum effect. Specifically, for each

month t, I sort all NYSE-AMEX6 firms with non-missing SUE data into deciles based on

their SUE from the most recent quarterly earnings announcement. I equally weight the

firms within each decile. The positions are held for six months, t+1 through t+6.7 The

difference in returns between the highest and lowest SUE deciles is the earnings

momentum factor.

1.3 Idiosyncratic volatility and earnings shocks

Table 1.1 presents the summary statistics for the five IVOL quintile portfolios. I form

five quintile portfolios each month based on IVOL from the previous month and report

the time-series averages of the firm characteristics for each portfolio. The Return column

shows that the IVOL discount, i.e., the average return difference between the high and

low IVOL quintiles, is -1.11% per month with a t- statistic of -3.13. The differences in

5
My results are robust to replacing value-weighted market return with equally weighted market return
when calculating abnormal return.
6
Data on earnings announcements are available for most Nasdaq stocks as of 1984. The inclusion of
Nasdaq stocks in the formation of the earnings momentum factor has no qualitative impact on my results. I
follow Chordia and Shivakumar (2006) and use NYSE-AMEX stocks to form the earnings momentum
factor.
7
I follow Jegedeesh and Titman (1993) in order to account for overlapping returns.
8
 Post- Size
IVOL quintile Return CAPM alpha FF3F alpha IVOL formation Age B/M (% of aggregate Momentum
IVOL market)
1 0.94 0.16 0.10 0.94 1.10 40.31 0.63 50.29 14.68
2 0.95 0.07 0.03 1.54 1.53 30.51 0.63 25.68 14.86
3 0.89 -0.08 -0.08 2.20 2.01 22.83 0.64 13.30 16.05
4 0.51 -0.53 -0.50 3.14 2.64 17.15 0.69 7.44 14.56
5 -0.17 -1.24 -1.35 5.46 3.85 13.38 0.95 3.29 4.82

5-1 -1.11 -1.40 -1.45 4.52 2.76 -26.93 0.32 -47.00 -9.85
t-test on 5-1 (-3.13) (-4.49) (-5.84) (67.27) (51.05) (-112.52) (11.01) (-20.99) (-6.24)

9
Table 1.1: Characteristics of IVOL-sorted portfolios
Value-weighted quintile portfolios are formed every month by sorting stocks based on idiosyncratic volatility relative to the Fama-French (1993) three-factor
model (using daily data from the prior month). Portfolio 1 (5) is the portfolio of stocks with the lowest (highest) idiosyncratic volatilities. The value-weighted
average characteristics of these quintile portfolios are computed monthly. The column labeled Return is measured in monthly percentage terms and applies to
total, not excess, simple returns. Columns 3 and 4 report Jensen's alphas with respect to the CAPM or the Fama-French (1993) three-factor model, respectively.
Column 5 reports the average idiosyncratic volatility relative to the Fama-French (1993) three-factor model using daily data from the previous month. Column
6 reports the average idiosyncratic volatility relative to the Fama-French (1993) three-factor model using daily data from the return month. The Age statistic is
the average number of years that a firm has data available on CRSP. B/M reports the average book-to-market ratio, and Size reports the average market
capitalization. Momentum is the cumulative average return over the past year (skipping the most recent month). The row "5-1" refers to the difference in
statistics between portfolios 5 and 1. The sample period is January 1972 to December 2008. The t-statistics are in parentheses.

9
CAPM and FF3F alphas are -1.40% (t = -4.49) and -1.45% (t = -5.84), respectively. Post-

formation IVOL is measured for the month after portfolio formation and it is

monotonically increasing across IVOL portfolios. Thus, stocks with high pre-formation

IVOL continue to experience high IVOL after portfolio formation. In addition, high

IVOL stocks are much younger, with an average age of 13 years, than low IVOL stocks,

which have an average age of 40 years. High IVOL stocks are also small-value firms with

poor returns for the preceding 12 month (excluding the most recent month). These

characteristics of high IVOL stocks are all associated with poor earnings performance, as

documented by the literature on size, value, and momentum effects 8. Furthermore, Irvine

and Pontiff (2009) show that firm-level cash flow volatility is an important determinant

of idiosyncratic stock volatility. Thus, it is possible that the large IVOL discount is due to

the difference in earnings performance between the high and the low IVOL stocks.

To investigate whether the earnings performance of high IVOL stocks is indeed

inferior to that of low IVOL stocks, Figure 1.19 plots the value-weighted average

earnings surprises for each of the IVOL-sorted portfolios from eight quarters before to

eight quarters after portfolio formation. Three measures – SUE, SUE1, and CAR – are

employed to capture earnings surprises.

Figure 1.1 shows that IVOL is associated with persistent differences in earnings

surprises. Specifically, high IVOL stocks experience more negative earnings shocks than

low IVOL stocks from two quarters before and to two quarters after portfolio formation.

8
See Fama and French (1995), La Porta et al. (1997), and Chan et al. (1996).
9
Figures 1A, 1B, and 1C plot SUE, SUE1, and CAR, respectively.
10
This evidence is consistent with Jiang et al. (2009), who show that IVOL is a negative

predictor of future earnings, although they do not examine pre-formation earnings

performance.

Figure 1.1: Earnings Shocks of IVOL-sorted portfolios

For each portfolio formation month from 1972 to 2008, stocks are sorted into five portfolios based on based on
idiosyncratic volatility relative to the Fama-French (1993) three-factor model (using daily data from the prior
month). Figures 1A, 1B, and 1C report the value-weighted average SUE, SUE1, and CAR, respectively, for
each portfolio eight quarters before and eight quarters after portfolio formation. SUE is defined as current
quarter earnings less earnings four quarters ago, and this change is standardized by the standard deviation of the
earnings changes over the prior eight quarters. SUE1 is defined similar to SUE except SUE1 is standardized by
the quarter-end share price. CAR is the average buy-and-hold abnormal returns for three days around the
earnings announcement date [-1, 0, +1]. Abnormal return is defined as: (daily return - value-weighted market
return).

11
 Figure 1.1 raises two questions about the IVOL discount. First, as high IVOL stocks

tend to have earnings performance that is inferior to low IVOL stocks prior to portfolio

formation, can the well-known earnings momentum effect help explain the IVOL

discount? This question focuses on whether the low returns of high IVOL stocks are due

to delayed price reactions to their poor earnings news prior to portfolio formation.

Second, as high IVOL stocks continue to perform poorly in earnings even after portfolio

formation, could these post-formation earnings shocks also contribute to the poor returns

of high IVOL stocks?

To gauge the magnitudes of the earnings shocks surrounding portfolio formation,

panel A of Table 1.2 reports the value-weighted average earnings surprises and the

average cross-sectional standard deviations of the earnings surprises of IVOL-sorted

quintile portfolios. As the IVOL portfolios are rebalanced monthly and earnings surprises

are measured quarterly, Newey-West t-statistics with three lags are reported in Table 1.2.

Panel A of Table 1.2 shows that high IVOL stocks experience large, negative earnings

shocks in the quarter just prior to portfolio formation, while low IVOL stocks experience

large positive shocks. Specifically, the average SUE of the highest IVOL quintile

is -0.21, while it is 0.95 for the lowest IVOL quintile. The SUE spread between the

extreme IVOL quintiles, therefore, is -1.16 (t = -20.85). SUE1 and CAR provide a similar

picture. The spreads in SUE1 and CAR between the highest and the lowest IVOL

quintiles are -1.85% (t = -3.33) and -1.53% (t = -6.01), respectively. These results suggest

that high IVOL stocks experience poor earnings performance prior to portfolio formation

12
 Panel A: Earnings shocks of IVOL sorted portfolios
Most recent SUE First quarter SUE Second quarter Third quarter Fourth quarter
IVOL Quintile prior to portfolio after portfolio SUE after portfolio SUE after portfolio SUE after portfolio
formation formation formation formation formation

0.95 0.88 0.82 0.77 0.73

1
[1.97] [2.13] [2.13] [2.16] [2.15]
0.74 0.66 0.63 0.59 0.56
2
[1.99] [2.17] [2.15] [2.18] [2.16]
0.55 0.44 0.39 0.35 0.36
3
[1.96] [2.14] [2.10] [2.12] [2.08]
0.22 0.05 0.08 0.06 0.15
4
[1.89] [2.11] [1.99] [1.98] [1.94]
-0.21 -0.45 -0.26 -0.14 -0.03
5
[1.83] [2.11] [1.82] [1.78] [1.71]

13
5-1 -1.16 -1.33 -1.08 -0.91 -0.75
t test on 5-1 (-20.85) (-23.85) (-21.34) (-18.14) (-14.77)
Table 1.2: Earnings surprises of IVOL-sorted portfolios
Value-weighted quintile portfolios are formed every month by sorting stocks based on idiosyncratic volatility relative to the Fama-
French (1993) three-factor model. Daily data from the previous month are used to compute idiosyncratic volatility and rebalance the
portfolio monthly. Panel A reports the means and average cross-section standard deviations (reported in square brackets) of earnings
surprises (SUE, SUE1, and CAR), one quarter before and four quarters after portfolio formation. Three measures are employed to
capture earnings surprises. SUE is defined as current quarter earnings less earnings four quarters ago, and this change is standardized
by the standard deviation of the earnings changes over the prior eight quarters. SUE1 is defined similar to SUE except SUE1 is
standardized by quarter-end share price. CAR is the average buy-and-hold abnormal returns for three days around the earnings
announcement date [-1, 0, +1]. Abnormal return is defined as: (daily return - value-weighted market return). Panel B reports the long-
term buy-and-hold characteristic-adjusted returns (adjusted for size and B/M) of the (high IVOL - low IVOL) portfolio. The
benchmark portfolio is based on an extension and variation of the matching procedure used in Daniel et al. (1997). The sample period
is January 1972 to December 2008. Newey-West (1987) t-statistics with three lags are reported in parentheses.

Continued
13
 Table 1.2 Continued
Most recent First quarter Second quarter Third quarter Fourth quarter
SUE1 prior to SUE1 SUE1 after SUE1 after SUE1 after
IVOL Quintile
portfolio after portfolio portfolio portfolio portfolio
formation (%) formation (%) formation (%) formation (%) formation (%)
0.14 0.10 0.03 -0.01 -0.08
1
[3.13] [3.74] [3.92] [4.23] [4.54]
0.09 0.01 -0.07 -0.25 -0.48
2
[4.23] [5.33] [5.54] [6.36] [6.84]
-0.06 -0.18 -0.35 -0.61 -0.42
3
[5.95] [7.72] [8.28] [9.31] [9.74]

14
-0.44 -1.06 -1.23 -1.35 -1.01
4
[8.99] [12.21] [12.47] [13.52] [13.69]
-1.71 -3.51 -2.67 -1.45 0.19
5
[16.54] [24.05] [22.12] [22.24] [21.60]

5-1 -1.85 -3.61 -2.70 -1.44 0.26

t test on 5-1 (-3.33) (-4.75) (-2.39) (-0.64) (1.20)
Continued

14
 Table 1.2 continued
Most recent First quarter Second quarter Third quarter Fourth quarter
CAR prior to CAR CAR after CAR after CAR after
IVOL Quintile
portfolio after portfolio portfolio portfolio portfolio
formation (%) formation (%) formation (%) formation (%) formation (%)
0.33 0.23 0.15 0.14 0.15
1
[4.63] [5.84] [5.06] [4.97] [4.93]
0.24 0.23 0.20 0.19 0.15
2
[6.17] [7.31] [6.39] [6.39] [6.34]
0.02 0.19 0.17 0.13 0.09
3
[7.79] [8.80] [7.86] [7.82] [7.78]
-0.43 -0.19 -0.02 0.10 0.02
4
[9.74] [10.19] [9.45] [9.39] [9.31]
-1.20 -0.56 -0.13 0.04 0.27
5
[13.34] [12.00] [11.71] [11.77] [12.20]

15
5-1 -1.53 -0.80 -0.29 -0.10 0.12
t test on 5-1 (-6.01) (-5.35) (-2.40) (-0.92) (1.20)

Panel B: Long term buy and hold returns (Adjusted for BM and Size)

IVOL Quintile First quarter return Semi-annual return Annual return

1 0.13 0.16 0.12

2 0.13 0.18 0.26
3 0.00 -0.02 0.19
4 -0.95 -1.46 -1.17
5 -2.75 -4.44 -5.18

5-1 -2.88 -4.61

15 -5.30
t test on 5-1 (-4.20) (-3.95) (-3.12)
and, importantly, that investors are surprised by such poor performance. Since an

extensive literature documents that firms tend to have lower stocks returns after poor

earnings surprises, it is natural to examine whether the IVOL discount is related to the

earnings momentum effect.

Panel A of Table 1.2 also shows that the difference in earnings performance between

the extreme IVOL quintiles continues in the periods following portfolio formation. For

instance, the spreads in the SUE, SUE1, and CAR between the highest and the lowest

IVOL quintiles in the quarter immediately after portfolio formation are -1.33 (t = -23.85),

-3.61% (t = -4.75), and -0.80% (t = -5.35), respectively. The SUE and SUE1 spreads are

actually greater in magnitude in the quarter following portfolio formation than prior to

formation. On the other hand, the CAR spread between the extreme IVOL quintiles is

smaller in magnitude in the quarter following portfolio formation than prior to formation.

The average firm makes one quarterly earnings announcement within three months of

portfolio formation. Therefore, one way to gauge the economic magnitude of the -0.80%

CAR spread between the extreme IVOL quintiles in the quarter following portfolio

formation is to compare it to the average three-month buy-and-hold abnormal returns of

the long-short IVOL portfolios (long on high IVOL quintile stocks and short low IVOL

quintile stocks). Panel B of Table 1.2 reports the average, buy-and-hold, characteristic-

adjusted returns (adjusted for size and book-to-market) of the IVOL quintiles. The

characteristic-adjusted returns procedure largely follows Daniel, Grinblatt, Titman, and

Wermers (1997) and is further motivated by Daniel and Titman (1997). The quarterly

16
buy-and-hold abnormal return spread is -2.88%. Therefore, the -0.80% spread in CAR

after portfolio formation accounts for 27.78% (0.80%/2.88%) of the quarterly IVOL

discount. In contrast, if the IVOL discount was evenly distributed across the three-month

holding period, we would expect to observe less than 5% of the IVOL discount occurring

in the days surrounding the earnings announcements.10 Moreover, high IVOL stocks

continue to surprise investors with poor earnings performance even during the second

earnings announcement after portfolio formation. The difference in CAR between the

high and low IVOL quintiles during the second quarterly earnings announcement period

is -0.29%. To put these numbers in perspective, the spread in characteristic-adjusted

returns between the extreme IVOL quintiles is -4.61% during the first six months after

portfolio formation. The combined spread of -1.09% in CAR around the two subsequent

post-formation announcements of quarterly earnings thus accounts for 23.64% of the six-

month, buy-and-hold, characteristic-adjusted returns. After two quarters, there is little

difference between the extreme IVOL quintiles’ abnormal returns around earnings

announcements.

Table 1.2 also shows that high IVOL stocks tend to have larger dispersion in SUE1

and CAR11 (reported in square brackets) both before and after portfolio formation. This

result is consistent with Vulteenaho’s (2002) finding that variations in firm-level stock

returns are mainly driven by variations in earnings news.

10
An average quarter has 66 trading days and I only remove three trading days out of each quarter.
Therefore, if the IVOL discount was evenly distributed across the three-month holding period, we would
expect 3/66, or 4.5%, of the IVOL discount to occur in the days surrounding the earnings announcement.
11
The difference in the standard deviation of SUE across IVOL quintiles is trivial. This is expected because
SUE is defined as changes in earnings divided by the standard deviation of earnings changes.
17
 To summarize, sorting stocks on the basis of IVOL yields large spreads in subsequent

returns (the IVOL discount). Furthermore, high IVOL stocks tend to have large, negative

earnings shocks before portfolio formation, and these poor earnings performance

continue to surprise for two quarters after portfolio formation. In the next two sections, I

analyze the importance of the earnings momentum effect and post-formation earnings

shocks in explaining the IVOL discount, respectively.

1.4 Earnings momentum and the IVOL discount

Section 1.3 demonstrates that high IVOL stocks tend to experience large, negative

earnings shocks prior to portfolio formation. An extensive literature documents that firms

reporting unexpectedly high earnings outperform firms reporting unexpectedly poor

earnings after the earnings announcements. Therefore, in this section, I investigate the

importance of earnings momentum in explaining the IVOL discount. Three methods are

employed to assess the impact of earnings momentum on the IVOL discount. First, I

double sort stocks into 25 portfolios based on their most recent SUE and IVOL12, and

study the effect of SUE on the IVOL discount. Second, I follow Chordia and Shivakumar

(2006) in forming the earnings momentum factor (PMN) and use this factor along with

the Fama and French (1993) three-factor (FF3F) model to compute the abnormal returns

of IVOL portfolios. Lastly, to ensure that the earnings momentum effect has been

properly accounted for, I use both double sorts and the PMN factor adjustment. This

12
This is a sequential sort. I first sort stocks into five SUE quintiles. Within each SUE quintile, I further
sort stocks into five IVOL quintiles.
18
procedure essentially combines the first and second approaches to control for the earnings

momentum effect.

1.4.1 Double-sorting on SUE and IVOL

Panel A of Table 1.3 reports the average returns and t-statistics of the 25 portfolios

resulting from the double-sorting procedure. This panel also reports the IVOL discount –

the difference in average returns between the highest and lowest quintiles of IVOL firms

– within each SUE quintile. First, the IVOL discount is monotonically decreasing in

SUE. Specifically, the IVOL discount is -1.41% (t = -2.76) among firms with the most

negative earnings surprises, while the IVOL discount is only -0.08% (t = -0.06) among

the firms with the most positive earnings surprises. The fact that the IVOL discount

resides mostly among the firms with worst earnings surprises is consistent with slower

diffusion of bad news documented in Hong, Lim, and Stein (2000), Hou (2007), Hou and

Moskowitz (2005), and Diether, Malloy, and Scherbina (2002). Second, to control for the

earnings momentum effect, I average the returns of each IVOL quintile over the five SUE

portfolios. Therefore, these IVOL quintile portfolios control for the differences in

earnings shocks. The average IVOL discount is -0.63% (t = -1.95), which is substantially

lower than the -1.11% (t = -3.13) IVOL discount produced by the univariate-sorted

(Table 1.1). Panel B of Table 1.3 reports the FF3F alpha and t-statistics of the 25 SUE-

and IVOL-sorted portfolios. The evidence in this panel largely agrees with the previous

analyses; the IVOL discount resides mostly among stocks with poor prior earnings

performance. The average IVOL discount across the five SUE quintiles is -0.98% (t

19
 Panel A: Returns on each of the 25 double-sorted portfolios (SUE and IVOL)

IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 0.76 0.75 0.62 -0.18 -0.65 -1.41 (-2.76)
2 0.71 0.80 0.86 0.51 -0.20 -0.91 (-1.82)
SUE 3 0.86 0.91 0.82 0.84 0.38 -0.49 (-0.62)
4 1.06 0.99 1.02 0.98 0.78 -0.28 (-0.40)
5 1.13 1.18 1.14 1.10 1.05 -0.08 (-0.06)
Average 0.90 0.93 0.89 0.65 0.27 Average (5-1) t(5-1)
t(Average) (4.81) (3.93) (3.13) (1.90) (0.65) -0.63 (-1.95)
Table 1.3: Interaction between earnings momentum and the IVOL discount
Value-weighted quintile portfolios are formed every month by first sorting stocks based on the most recent SUE. Within each SUE

20
quintile, stocks are further sorted into five quintiles based on idiosyncratic volatility relative to the Fama-French (1993) three-factor
model. Daily data from the previous month are used to compute idiosyncratic volatility and rebalance the portfolio monthly. This
double-sorting procedure produces 25 portfolios. Panels A and B report the average returns and alphas obtained from Fama-French
(1993) three-factor model, respectively. The entry “Average” denotes the average returns of each IVOL quintile across the five SUE
portfolios. The entry “Average (5-1)” denotes the differences in average returns between the highest and lowest IVOL portfolios.
Panel C reports the time-series results of regressing excess returns on the Fama-French three-factor model and the earnings
momentum factor (PMN). The column labeled "FF3F_PMN alpha" reports the time-series intercept (alpha) of the regression (in
percentage). The last four columns of Panel B report the estimated loadings on the market factor (MKTRF), the size factor (SMB),
the value factor (HML), and the earnings momentum factor (PMN). “Average return on PMN (%)” reports the average monthly
returns, in percentage, of the earnings momentum factor (PMN). *, **, and *** denote significance at the 10%, 5%, and 1% levels,
respectively (applies only to panel C column labeled “Loadings on PMN”). The sample period is January 1972 to December 2008.
The t-statistics are in parentheses.
Continued

20
 Table 1.3 Continued

Panel B: Fama-French three-factor alpha on each of the 25 double-sorted portfolios (SUE and IVOL)

IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 -0.22 -0.29 -0.45 -1.28 -1.98 -1.76 (-4.21)
2 -0.28 -0.25 -0.29 -0.62 -1.56 -1.28 (-4.22)
SUE 3 -0.06 -0.09 -0.23 -0.25 -0.94 -0.88 (-3.40)
4 0.23 0.07 0.08 -0.03 -0.34 -0.57 (-1.98)
5 0.38 0.41 0.31 0.27 -0.02 -0.40 (-1.55)
Average 0.01 -0.03 -0.12 -0.38 -0.97 Average (5-1) t(5-1)
t(Average) (0.20) (-0.47) (-1.23) (-3.13) (-4.92) -0.98 (-4.51)

Panel C: Exposures to systematic component of earnings momentum

21
FF3F_PMN Loadings on Loadings on Loadings on Loadings on
alpha MKTRF SMB HML PMN
IVOL Quintile
1 0.04 0.89 -0.23 0.18 0.05***
2 0.12 1.10 -0.08 0.07 -0.08***
3 0.06 1.22 0.23 -0.08 -0.13***
4 -0.11 1.30 0.51 -0.25 -0.37***
5 -0.62 1.34 0.87 -0.16 -0.69***

5-1 -0.66 0.42 1.08 -0.37 -0.74

t-test on 5-1 (-2.56) (7.99) (13.75) (-3.87) (-7.15)
Average return on PMN factor (%) 0.90

21
= 4.51) per month. Although the -0.98% FF3F alpha is still economically and

statistically significant, the univariate-sorted 5-1 IVOL portfolio produces an even larger

FF3F alpha spread (-1.45% with t = -5.84; see Table 1.1). Therefore, controlling for the

most recent earnings performance reduces the IVOL discount substantially.

1.4.2 Momentum factor and the IVOL discount

Panel C of Table 1.3 reports the intercepts from regressing the excess returns of each

IVOL quintile on a four-factor model in which the PMN factor is added to the FF3F

model. The last column of panel C shows that the PMN loading is monotonically

declining in IVOL. The spread of the PMN loadings between the extreme IVOL quintiles

is -0.74. This suggests that high (low) IVOL firms co-move closely with negative

(positive) earnings surprise firms, which is consistent with earlier results that show that

high (low) IVOL firms tend to experience more negative (positive) earnings shocks prior

to portfolio formation.

To gauge whether this -0.74 spread in PMN loadings across the extreme IVOL

quintiles is economically significant, I report the average premium on the PMN factor

during my sample period in the bottom row of panel C. On average, the PMN factor earns

0.90% per month and, therefore, the -0.74 spread in the PMN loadings accounts for -0.74

x 0.90% = -0.67% of the difference in average returns between the extreme IVOL

quintiles. As a result, the spread in the FF3F_PMN alpha between the highest and the

lowest IVOL quintiles is -0.66% with a t-statistic of -2.56 (Table 1.3, panel C, column 2),

compared to the -1.45% (t = -5.84) alpha spread obtained from the FF3F model (Table

22
1.1, column 4) and the -1.11% (t = -3.13) raw return spread (Table 1.1, column2). Thus,

controlling for the earnings momentum effect using the PMN factor provides a

conclusion similar to that obtained using double sorts in the previous subsection. Again,

the earnings momentum effect plays an important role in explaining the IVOL discount.

1.4.3 Combining double-sorting and the earnings momentum factor

Thus far, the earnings momentum effect has been controlled for using either double-

sorting or the earnings momentum factor, PMN. To ensure that the earnings momentum

effect has been adequately accounted for, I combine these two approaches. Panel A of

Table 1.4 reports the PMN loadings of the 25 SUE/IVOL sorted portfolios. PMN loading

is decreasing in IVOL across all five SUE quintiles, and the spreads in loadings between

the extreme IVOL quintiles are all economically and statistically significant. The average

spread in the PMN loadings across all five SUE quintiles is -0.65 with a t-statistic

of -7.16. This suggests that high IVOL stocks are highly negatively exposed to the

earnings momentum factor regardless of whether they reside in a positive- or negative-

SUE quintile.

The smallest PMN loadings spread in magnitude is -0.20 (the highest SUE quintile).

Since the PMN premium earns 0.90% per month, the -0.20 PMN loadings spread

accounts for -0.20 x 0.90% = -0.18% of the returns spread between the extreme IVOL

quintiles among the highest SUE stocks. This is a sizable amount given that the IVOL

discount, as measured by FF3F alpha, is only -0.40% among the highest SUE stocks

(Table 1.3, panel B).

23
Panel B of Table 1.4 reports the FF3F_PMN alpha of the 25 SUE/IVOL-sorted

portfolios. Consistent with the prior results, the IVOL discount is substantially weaker

when the PMN factor is introduced into the FF3F model. The average IVOL discount

across all five SUE portfolios, as measured by the average spread in FF3F_PMN alpha

between the extreme IVOL quintiles, is only -0.29% per month with a t-statistic of -1.28.

In comparison, sorting stocks into five quintiles based on IVOL alone produces a

FF3F_PMN alpha spread of -0.66% with a t-statistic of -2.56 (Table 1.3, panel C). On the

other hand, double-sorting stocks on IVOL and SUE produces an average IVOL discount,

as measured by the FF3F alpha, of -0.98% (t = -4.51) (Table 1.3, panel B). Thus, this

combined approach seems to provide the most complete control of the earnings

momentum effect in terms of explaining the IVOL discount.

The evidence in this section presents a clear picture of how prior earnings

performance is related to the IVOL discount. Specifically, investors under-react to

earnings news, especially for those firms with most negative earnings surprises and high

IVOLs. This result is consistent with the evidence that bad news diffuses more slowly.

Bali and Cakici (2008) show that high IVOL stocks are typically small, illiquid, and low-

priced stocks, and that these characteristics can also be viewed as short-sale constraints.

Thus, a significant portion of the IVOL discount reflects a failure to appropriately

incorporate negative earnings news into stock prices due to the market frictions that are

associated with these high IVOL stocks.

24
 Panel A: loadings on PMN factor
IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 -0.42 -0.37 -0.63 -0.88 -1.34 -0.92 (-5.20)
2 -0.07 -0.35 -0.49 -0.50 -1.00 -0.93 (-7.46)
SUE 3 0.03 -0.02 -0.23 -0.40 -0.54 -0.57 (-5.13)
4 0.13 0.23 0.10 0.04 -0.47 -0.60 (-4.83)
5 0.20 0.14 0.14 0.11 0.00 -0.20 (-1.79)
Average -0.03 -0.08 -0.22 -0.33 -0.67 Average (5-1) t(5-1)
t(Average) (-1.15) (-2.76) (-5.58) (-6.40) (-8.40) -0.65 (-7.16)

Panel B: Fama-French three-factor and PMN model alpha on each of the 25 double-sorted portfolios (SUE and IVOL)
IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 0.23 0.11 0.22 -0.33 -0.54 -0.77 (-1.73)
2 -0.20 0.13 0.23 -0.09 -0.48 -0.28 (-0.90)

25
SUE 3 -0.09 -0.07 0.01 0.19 -0.36 -0.28 (-0.99)
4 0.10 -0.17 -0.02 -0.08 0.16 0.07 (0.21)
5 0.16 0.26 0.17 0.15 -0.02 -0.18 (-0.64)
Average 0.04 0.05 0.12 -0.03 -0.25 Average (5-1) t (5-1)
t(Average) (0.67) (0.74) (1.21) (-0.25) (-1.24) -0.29 (-1.28)
Table 1.4: Combination of the two approaches to control for the earnings momentum
Value-weighted quintile portfolios are formed every month by first sorting stocks based on the most recent SUE. Within each SUE
quintile, stocks are further sorted into five quintiles based on idiosyncratic volatility relative to the Fama-French (1993) three-factor
model. Daily data from the previous month are used to compute idiosyncratic volatility and rebalance the portfolio monthly. This
double-sorting procedure produces 25 portfolios. Panel A reports the loadings on the earnings momentum factor (PMN) of the 25
portfolios (estimated with a four-factor model encompassing the three Fama-French factors and the earnings momentum factor).
Panel B reports the intercepts (alphas) from time-series regressions of the value-weighted excess returns on a four-factor model in
which the earnings momentum factor (PMN) is added to the Fama-French (1993) three-factor model. The entry “Average” denotes
the average return of each IVOL quintile across the five SUE portfolios. The entry “Average (5-1)” denotes the difference in average
returns between the highest and lowest IVOL portfolios. The t-statistics are in parentheses.

25
1.5 Post-formation earnings shocks and the IVOL discount

1.5.1 Adjusting realized returns with post-formation earnings shocks

Earlier results (see Table 1.2 and Figure 1.1) suggest that high IVOL stocks

experience earnings disappointments both before and after portfolio formation. This

section investigates how post-formation earnings shocks may play a role in explaining the

IVOL discount. To examine this issue, I adjust monthly stock returns for post-formation

earnings shocks using the following procedures:

1) If there is an earnings announcement within a given month, I replace the daily

returns around the earnings announcement [-1,0,+1] with 0%, with time 0

being the earnings announcement date.13

2) I compound the daily returns over that month using these “adjusted” daily

returns. This new monthly return is called adjusted return.

3) If no earnings announcement takes place during that month, the adjusted

return equals the CRSP monthly return for that month.

4) Alpha is obtained by using the adjusted returns in excess of the risk-free rate

with respect to one of the asset pricing models, such as CAPM, the FF3F

model, or the FF3F_PMN model. The alpha obtained using the adjusted

returns is called the adjusted alpha.

The goal here is to explore the effect of post-formation earnings shocks on the IVOL

discount. If post-formation earnings shocks are not important in explaining the IVOL

13
Replacing returns with risk-free rate, value, or equally weighted market returns does not qualitatively
change the results.
26
discount, the removal of the three-day return around earnings announcement when

calculating monthly returns should not substantially affect the IVOL discount. Panel A of

Table 1.5 reports the average number of firms that announce earnings each month. Panel

B of Table 1.5 reports the adjusted monthly returns and adjusted alphas of the IVOL

quintile portfolios.

On average, the lowest IVOL quintile has 256 firms reporting quarterly earnings each

month, while the highest IVOL quintile has 204 firms. The overall average number of

firms in each quintile (with or without earnings announcements during the month) is 858.

Therefore, the return adjustment procedure affects only (256 + 204)/1,716 = 26.81% of

firms in quintiles one and five. In addition, return adjustment procedure only involves

removing three daily returns, or 13.64%, of the twenty-two trading days in an average

month. Therefore, if the IVOL discount is randomly distributed across trading days and if

post-formation earnings shocks are irrelevant for the IVOL discount, then the adjusted

return procedure should only remove 26.81% x 13.64% = 3.66% of the IVOL discount.

Column two of panel B of Table 1.5 shows that the spread of the adjusted returns

between the extreme IVOL quintiles is -0.83%, compared to the unadjusted return spread

of -1.11% (Table 1.1). Thus, the adjustment for post-formation earnings shocks reduces

the IVOL spread by [1.11-0.83]/1.11 = 25.23%, which is substantially higher than the

3.66% benchmark.

Columns 3, 4, and 5 of panel B report the CAPM, the FF3F, and the FF3F_PMN

adjusted alpha, respectively. The CAPM, the FF3F, and the FF3F_PMN adjusted alpha

27
Panel A: Number of firms that report earnings
Average number Median Maximum Minimum
of firms report number of number of firms number of
quarterly firms report report quarterly firms report
IVOL Quintile
earnings quarterly earnings (per quarterly
(per month) earnings month) earnings (per
(per month) month)
1 256 208 899 14
2 255 223 794 13
3 245 231 716 2
4 232 220 634 1
5 204 171 572 5

Average number of firms per quintile (monthly, with or without earnings announcement) 858

Panel B: Adjusting returns with ex-post earnings shocks

CAPM FF3F FF3F_PMN Loading Loading Loading Loading

Adjusted
IVOL Quintile Adjusted Adjusted Adjusted on on on on
Return
alpha alpha alpha MKTRF SMB HML PMN
1 0.81 0.06 0.01 -0.05 0.81 -0.21 0.15 0.06
2 0.79 -0.05 -0.09 -0.04 0.99 -0.07 0.07 -0.05
3 0.75 -0.17 -0.17 -0.03 1.12 0.20 -0.07 -0.14
4 0.54 -0.45 -0.43 -0.06 1.19 0.47 -0.23 -0.34
5 -0.02 -1.05 -1.15 -0.47 1.23 0.80 -0.14 -0.64

5-1 -0.83 -1.11 -1.16 -0.42 0.42 1.01 -0.29 -0.70

t-test on 5-1 (-2.51) (-3.76) (-4.91) (-1.68) (7.84) (13.30) (-3.46) (-7.12)
Table 1.5: Returns adjusted for post-formation earnings shocks
Panel A reports the average, median, maximum, and minimum numbers of firms reporting quarterly earnings per month.
For reference, the bottom row of panel A reports the overall average number of firms per quintile in the sample (with and
without earnings announcements). Panel B reports the value-weighted average adjusted returns of the idiosyncratic
volatility sorted portfolios. To compute adjusted returns, three daily returns, [-1, 0, +1] around earnings announcement
dates are replaced with zero, and the daily returns within the month are computed to derive the adjusted return. CRSP
monthly return is used if no earnings announcement was made during a month. Columns 3 to 5 of Panel B report the
intercepts (alphas) from time-series regressions of the value-weighted excess adjusted returns on the CAPM model, the
Fama-French (1993) three-factor model, and a four-factor model in which the earnings momentum factor (PMN) is
added to the Fama-French (1993) three-factor model. The last four columns in Panel B report the loadings on the market
factor (MKTRF), the size factor (SMB), the value factor (HML) and the earnings momentum factor (PMN). These
estimated loadings are obtained by regressing excess adjusted return on MKTRF, SMB, HML, and PMN. The sample
period is from January 1972 to December 2008. The t-statistics are in parentheses.

28
spreads are -1.11% (t = -3.76), -1.16% (t = -4.91), and -0.42% (t = -1.68), respectively,

while the corresponding unadjusted alpha spreads are -1.40% (t = -4.49), -1.45% (t

= -5.84), and -0.66% (t = -2.56) (see Table 1.1 and 1.3). Therefore, the respective

reductions in the CAPM, the FF3F, and the FF3F_PMN alphas are 21%, 20%, and 36%.

These reductions are all substantially higher than the 3.66% benchmark. This suggests

that the differences in loadings on MKTRF, SMB, and HML cannot subsume the

importance of post-formation earnings shocks in explaining the IVOL discount.

The results so far in this section have demonstrated the importance of post-formation

earnings shocks in explaining the IVOL discount. However, if the observed IVOL

discount in realized return is due to post-formation earnings shocks, then we should not

expect to find the IVOL discount (or at least should find a weaker IVOL discount) when

we study the relation between IVOL and pre-formation ex-ante expected returns. The

next sub-section explores this hypothesis in detail.

1.5.2 Implied cost of capital and the IVOL discount

Does the market expect high IVOL stocks to earn lower returns than low IVOL stocks

prior to portfolio-formation? To answer this question, I estimate the firm-level ex-ante

expected returns using the implied cost of capital (ICC) from the account and finance

literatures.

The ICC of a firm is the internal rate of return that equates the firm’s stock price to

the present value of expected future cash flows. In other words, the ICC is the discount

29
rate that the market uses to discount the expected future cash flows. Unlike realized

returns, the ICC is not subject to post-formation shocks, because the ICC is estimated

prior to portfolio formation using forecasted future cash flow and firm’s market equity.

The common approach in the ICC literature is to use analysts’ earnings forecasts to

proxy for cash flow expectations. However, recent empirical evidence suggests that the

performance of the analyst-based ICC as a proxy for expected returns is less than fully

satisfactory. For instance, several studies examine the relation between the analyst-based

ICC and future realized returns and find only mixed results 14. Furthermore, analysts tend

to be overly optimistic in their earnings forecasts15. Another major concern is coverage.

The IBES analyst data are only available after the late 1970s, and small firms and

financially distressed firms are underrepresented (La porta (1996), Hong et al. (2000),

and Diether et al. (2002)). The lack of coverage for these firms posts a severe challenge

on analyst-based ICC in studying the IVOL discount, since, as reported in Table 1.1, high

IVOL firms are younger and much smaller in size; therefore, we may not obtain a

representative sample of high IVOL firms when analyst-based ICC is employed. Indeed, I

find that analyst-based ICC is only available for a quarter of the high IVOL stocks.

To address these concerns, I follow Hou, Van Dijk, and Zhang (HVZ, 2012) and use

earnings forecasts generated by simple cross-sectional model instead of analysts’ forecast

to proxy for cash flow expectations. HVZ shows that earnings forecasts generated by the

14
See Gebhardt, Lee, and Swaminathan (2001), Easton and Monahan (2005), and Guay, Kothari, and Shu
(2011)
15
See Francis and Philbrick (1993), Dugar and Nathan (1995), and Easton and Sommers (2007).
Furthermore, Abarbanell and Bushee (1997) and Francis and Philbrick (1993) find large valuation errors
when analyst’s forecasts are used in valuation models.
30
model exhibit much lower levels of forecast bias, and more importantly, much higher

levels of earnings response coefficient than analysts’ forecasts. The latter finding

suggests that the earnings forecasts from the cross-sectional model represent a better

proxy for market expectations of future earnings. Another major advantage of the model-

based approach is that it uses the large cross-section of individual firms to compute

earnings forecasts and therefore generates statistical power while imposing minimal

survivorship requirements. This model-based approach allows me to compute ICC for

more than 86% of the high IVOL firms. Specifically, I use the following cross-sectional

model to forecast firm-level earnings.

Where denotes the earnings of firm in year ( = 1 to 5), is the total

assets, is the dividend payment, is a dummy variable that equals 1 for dividend

payers and 0 otherwise, is a dummy variable that equals 1 for firms with

negative earnings and 0 otherwise. is accruals. is firm’s market value.

For each month between 1972 and 2008, I estimate the pooled cross-sectional regression

(1) using the previous 60 months of data. To ensure that the model-based earnings

forecasts are based on information that is publicly available at the time of ICC estimation,

I impose a minimum report lag of three months. That is, at the end of month j, the most

recent account variables that can be used to forecast future earnings are from fiscal year

prior to month j-3. MV is obtained at the end of month j. The model-based earnings
31
 Figure 1.2: Timeline of earnings forecasts and ICC estimation.
This figure illustrates the timeline of the earnings forecasts and the ICC estimation. At the end of
every month j, I obtain the model-based earnings forecasts for firms with fiscal year ends (FYE) from
month j-3 to month j-14 as the product of (1) the accounting variables from the most recent FYE
(From month j-3 to month j-14, assumed to be known by month j) and (2) the coefficients of the cross-
sectional earnings model estimated using the previous 60 months of data (also assumed to be known
by month j). I compute the four individual model-based ICCs (GLS, CT, OJ, and Gordan), and a
composite ICC (the average of the four individual ICCs) for each firm using its end-of-month j market
equity and the model-based earnings forecasts for the next twelve months. I then match the individual
and composite ICCs with month j+1 realized stock returns.

32
forecasts are then obtained by multiplying their accountings variables (from fiscal year

end of month j-3 or before) with the coefficients from the pooled regression estimated

using the previous 60 months of data. Figure 1.2 illustrates the timing of the data in

estimating (1). Thus, the earnings forecasts obtained from the cross-sectional model are

strictly out of sample.

It is important to note that the earnings forecasts, and hence the ICC estimates, for

each firm are updated monthly due to the fluctuation in firm value. The monthly updating

feature of this model could be adventurous in studying the IVOL discount because the

IVOL portfolios are also updated monthly. The idea behind adding MV to the original

HVZ model is that market value of a firm should also contain useful information about

future cash flow (See Ball and Brown (1968), Beaver, Lambert, and Morse (1980),

Beaver, Lambert, and Ryan (1987), Collins, Kothari, and Rayburn (1987), Basu (1997),

and Ryan and Zarowin (2003)).

Panel A of Table 1.6 reports the average coefficients from the pooled regressions

estimated each month from January of 1972 to December of 2008 and their time-series

Newey-West t-statistics. To conserve space, I only report the results for the one-, two-,

and three-year ahead earnings regressions. The average coefficient and t-statistics for

each independent variables are largely consistent with Fama and French (2006), Hou and

Robinson (2006), Hou and Van Dijk (2012), and HVZ. Panel A also shows the cross-

sectional model captures a substantial part of the variation in the future earnings

33
 Panel A: Coefficients estimates of the cross-sectional earnings model
LHS Intercept At Dt DDt Et Neg Et ACt MVt Adj R2

Et+1 Coefficient -3.2124 0.0027 0.1896 0.5981 0.7025 0.7744 -0.0594 0.0160 0.85
t-stat (-5.37) (9.09) (8.64) (1.76) (44.36) (0.83) (-7.24) (14.77)

Et+2 Coefficient -3.7923 0.0059 0.2929 0.1098 0.5889 2.1012 -0.0707 0.0230 0.80
t-stat (-5.26) (12.10) (10.30) (0.22) (34.83) (2.38) (-5.12) (13.74)

Et+3 Coefficient -3.6673 0.0086 0.3569 -0.3860 0.5752 4.0755 -0.0698 0.0250 0.77
t-stat (-4.83) (11.39) (10.50) (-0.65) (23.01) (4.84) (-4.07) (12.84)

Panel B: Correlations between individual ICCs (Jan1972 to Dec2008)

34
Gordan GLS CT OJ Composite
Gordan 1
GLS 0.72 1
CT 0.76 0.84 1
OJ 0.92 0.76 0.83 1
Composite 0.96 0.81 0.86 0.96 1
Table 1.6: Earnings forecast and implied cost of capital
Panel A reports the average coefficients and adjusted R2 from pooled regressions estimated each month from January of 1972 to December
of 2008 using previous 60 months of data. Et+1, Et+2, and Et+3 are the one-, two-, and three-year ahead earnings. At is total asset. Dt is the
dividend payment. DDt is a dummy variable that equals 1 for dividend payers and 0 otherwise. Neg Et is a dummy variable that equals 1 for
firms with negative earnings and 0 otherwise. ACt is accruals. MVt is market value that equals to the product of number of shares
outstanding and price per share. Panel B reports the correlations between the individual and composite ICCs. Panel C reports the value-
weighted average ICC (in %) for each idiosyncratic volatility sorted portfolios using five approaches to compute ICC (GLS, CT, OJ,
Gordan, and Composite). Newey-West t-statistics with 12 lags are in parentheses. Average number of firms in each idiosyncratic volatility
sorted portfolios are reported as n(Composite) and n(Analysts).
34
Continued
 Table 1.6 Continued
Panel C: Implied Cost of Capital
IVOL
Gordan GLS CT OJ Composite n (Composite) n (Analysts)
Quintiles
1 0.48 0.61 0.55 0.48 0.53 675 499
2 0.58 0.71 0.64 0.58 0.63 722 487
3 0.62 0.76 0.66 0.61 0.67 754 435
4 0.66 0.80 0.67 0.65 0.70 766 349
5 0.85 0.89 0.78 0.81 0.86 743 204

35
5-1 0.38 0.28 0.23 0.33 0.32
t-test on (5-1) (6.09) (10.45) (7.37) (7.69) (7.75)

35
performance across firms. The average regressions adjusted R2 are 85%, 80%, and 77%

for the one-, two-, and three-year ahead earnings regressions, respectively.

Previous studies have developed a variety of methods to estimate the ICC. To ensure

that our results are not driven by any specific method, my main analyses are based on a

“composite” ICC measure that is the average of the following four individual ICC

estimates: Claus and Thomas (CT, 2001), Gebhardt, Lee, and Swaminathan (GLS, 2001),

Gordan and Gordan (Gordan, 1997), and Ohlson and Juettner-Nauroth (OJ, 2005).

Following HVZ, I only require a firm to have at least one non-missing values from the

four individual ICC estimates. However, I also report the individual ICC estimates, and

the results are largely the same. These individual ICC estimates differ in the use of

forecasted earnings, the explicit forecast horizon, and the assumptions regarding short-

term and long-term growth rates. They can be broadly grouped into three categories: CT

and GLS are based on the residual income valuation model; OJ is abnormal earnings

growth-based model; Gordon is based on the Gordon growth model16.

Panel B reports the correlations between the individual ICCs and between the

individual and composite ICCs. The four individual model-based ICCs are generally

highly correlated with each other and with the composite ICC. The correlation ranges

from a low of 0.72 (between Gordan and GLS) to a high of 0.96 (between composite and

Gordan/OJ).

16
Appendix A of HVZ provides detailed description for each ICC estimate.
36
 Panel C indicates that model-based ICC covers a much larger sample of firms than

analyst-based ICC. This coverage advantage is especially true among high IVOL stocks.

For instance, Table 1.5 indicates an average of 858 firms resides among the high IVOL

quintile, and the model-based ICC covers 743 or 87% of those firms, while the analyst-

based covers only 204 or 24% of those firms. The lack of coverage by analysts for high

IVOL firms poses serious concerns for using analysts-based ICCs in studying the relation

between ex-ante expected returns and IVOL.

Most importantly, panel C shows that there is a monotonic relation between the

model-based ICCs and IVOL17. That is, all model-based ICC indicate that, if anything,

market is expecting high IVOL stocks to generate higher returns than low IVOL stocks.

The 5-1 model-based ICCs spread ranges from 0.23% to 0.38% per month18. This result

is in sharp contrast with the results obtained from using realized returns (Table 1.1 shows

the 5-1 spread using realized returns is -1.11% per month). The finding of this section is

in support of the post-formation earnings shocks explanation for the IVOL discount. That

is, high IVOL stocks consistently experience negative post-formation earnings shocks

that cause their realized returns to appear lower than their expected returns.

The results so far have illustrated that both pre- and post-formation earnings shocks

are each individually important in explaining the IVOL discount. A natural question then

17
Since I use annual earnings in estimating ICC, the resulting ICC is then the discount rate for 1 year in the
future. I divide the estimated ICC by twelve to proxy for monthly ICC.
18
I also use analyst-based earnings forecasts to estimate ICCs, and the Composite 5-1 spread is -0.01% per
month.
37
is: What is the collective impact of pre- and post-formation earnings shocks on the IVOL

discount? The next section of this paper addresses this question directly.

1.6 Earnings momentum effect and post-formation earnings shocks

The previous two sections show that the earnings momentum effect and post-

formation earnings shocks both play a role in explaining the IVOL discount. In this

section, I combine these two effects, and quantify the impact of pre-formation and post-

formation earnings shocks on the IVOL discount. Table 1.7 presents the results.

Panel A of Table 1.7 reports the average adjusted returns and the t-statistics of the 25

SUE/IVOL-sorted portfolios. The average IVOL discount across all five SUE quintiles is

-0.46% (t = -1.52) per month when computed with adjusted returns, compared with the

average IVOL discount of -0.63% (t = -1.95) when computed using unadjusted returns

(Table 1.3, panel A). Hence, adjusting returns for post-formation earnings shocks further

reduces the IVOL discount by (0.63-0.46)/0.63 = 27% even after controlling for the

earnings momentum effect.19 This confirms that the earnings momentum effect and post-

formation earnings shocks are both important in explaining the IVOL discount. Panel B

of Table 1.7 reports the FF3F adjusted alpha of the 25 portfolios. The average FF3F

adjusted alpha across all five SUE quintiles is -0.78% (t = -3.76), while the average FF3F

alpha is -0.98% (t = -4.51) (Table 1.3, panel B) when computed using unadjusted returns.

The reduction in FF3F alpha is (0.98-0.78)/0.98 = 20%.

19
I also use the earnings momentum factor along with adjusted returns to study the combined effect of
earnings shocks on the IVOL discount. The result is presented in column four of Panel B of Table 1.5. The
use of adjusted returns reduces the FF3F_PMN alpha by 24 basis points.
38
 Panel A: Adjusted returns on each of the 25 double-sorted portfolios (SUE and IVOL)

IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 0.64 0.60 0.53 -0.14 -0.64 -1.28 (-2.76)
2 0.64 0.63 0.82 0.56 -0.04 -0.68 (-1.82)
SUE 3 0.69 0.80 0.72 0.81 0.49 -0.20 (-0.62)
4 0.92 0.88 0.88 0.92 0.78 -0.14 (-0.40)
5 1.00 0.98 0.93 0.97 0.98 -0.02 (-0.06)
Average 0.78 0.78 0.78 0.62 0.31 Average (5-1) t(5-1)
t(Average) (4.55) (3.65) (2.99) (1.98) (0.82) -0.46 (-1.52)
Table 1.7: The combination of all adjustments
Value-weighted quintile portfolios are formed every month by first sorting stocks based on the most recent SUE.

39
Within each SUE quintile, stocks are further sorted into five quintiles based on idiosyncratic volatility relative to the
Fama-French (1993) three-factor model. Daily data from the previous month is used to compute idiosyncratic
volatility and rebalance the portfolio monthly. This double-sorting procedure produces 25 portfolios. Panels A, B, and
C report the average adjusted returns, adjusted Fama-French three-factor alpha, and adjusted alpha obtained from a
four-factor model in which the earnings momentum factor (PMN) is added to the Fama-French (1993) three-factor
model, respectively. Adjusted returns are obtained by replacing three daily returns, [-1, 0, +1], around earnings
announcement date with zero and compounding the daily returns within the month to derive the adjusted return. CRSP
monthly return is used if no earnings announcement was made during a month. Adjusted alpha (either from the Fama-
French (1993) three-factor model or from the four-factor model mentioned above) is the time-series intercept derived
from regressing excess adjusted returns on the factors. The entry “Average” denotes the average returns of each IVOL
quintile across the five SUE portfolios. The entry “Average (5-1)” denotes the difference in average returns between
the highest and lowest IVOL portfolios. The t-statistics are in parentheses.

Continued

39
 Table 1.7 Continued
Panel B: Adjusted Fama-French three-factor alpha on each of the 25 double-sorted portfolios (SUE and IVOL)

IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 -0.31 -0.39 -0.48 -1.14 -1.91 -1.60 (-4.10)
2 -0.28 -0.37 -0.25 -0.54 -1.29 -1.02 (-3.54)
SUE 3 -0.20 -0.14 -0.28 -0.21 -0.77 -0.57 (-2.28)
4 0.14 0.01 -0.03 -0.07 -0.30 -0.44 (-1.62)
5 0.29 0.25 0.13 0.15 0.03 -0.26 (-1.12)
Average -0.07 -0.13 -0.18 -0.36 -0.85 Average (5-1) t(5-1)
t(Average) (-1.27) (-2.10) (-2.02) (-3.07) (-4.48) -0.78 (-3.76)

40
Panel C: Adjusted Fama-French three-factor and PMN model alpha on each of the 25 double-sorted portfolios (SUE and IVOL)

IVOL
1 2 3 4 5 5-1 t-test on 5-1
1 0.08 -0.03 0.21 -0.31 -0.53 -0.61 (-1.47)
2 -0.22 -0.02 0.32 -0.06 -0.25 -0.03 (-0.10)
SUE 3 -0.26 -0.16 -0.03 0.11 -0.13 0.13 (0.49)
4 0.05 -0.19 -0.12 -0.13 0.16 0.11 (0.37)
5 0.10 0.02 -0.02 0.04 -0.01 -0.11 (-0.43)
Average -0.05 -0.07 0.07 -0.07 -0.15 Average (5-1) t(5-1)
t(Average) (-0.83) (-1.11) (0.76) (-0.56) (-0.79) -0.10 (-0.48)

40
 To ensure that the earnings momentum effect is adequately accounted for, I also

control for the earnings momentum factor when computing the alpha for each of the 25

SUE/IVOL-sorted portfolios. Panel C of Table 1.7 reports the FF3F_PMN adjusted alpha

of these 25 portfolios. The average adjusted FF3F_PMN alpha across all five SUE

quintiles is -0.10% (t = -0.48), compared with -0.29% (t = -1.28) (Table 1.4, panel B)

when the alpha is computed using unadjusted returns. The 19 basis-point reduction in the

IVOL discount is similar in magnitude to the reduction in raw returns and FF3F alpha, as

reported in panels A and B, respectively.

In sum, the results in this section show that both pre- and post-formation earnings

shocks are important in explaining the IVOL discount. Furthermore, when I combine the

two effects together, I am able to explain 91% of the IVOL discount.

1.7 Fama-MacBeth cross-sectional regressions

Table 1.8 examines the relations among earnings momentum, post-formation earnings

shocks, and the IVOL discount using Fama and MacBeth (1973) (FM) regressions. The

regressions adds further robustness to the results, as they include all securities without

imposing quintile breakpoints; they allow for the inclusion of more controls in returns,

including liquidity measures; and they provide an alternative weight scheme for

portfolios.20 The cross-section of stock returns in excess of the one-month T-bill rate each

20
Each coefficient in a FM regression is the return to the minimum variance portfolio with weights that
sum to zero, weighted characteristic on its corresponding regressor that sums to one, and weighted
characteristics on all other regressors that sum to one. The weights are tilted toward stocks with the most
extreme (volatile) returns.
41
 Panel A: Base case regression (without adjusting for post-formation earnings shocks)

Excess return Excess return Excess return Excess return

Excess return filtered by filtered by Excess return filtered by filtered by
FF3F FF3F and PMN FF3F FF3F and PMN

Raw Purged Raw Purged Raw Raw Purged Raw Purged Raw
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Size -0.13 -0.11 -0.10 -0.12 -0.18 -0.14 -0.12 -0.11 -0.13 -0.19
(-3.54) (-4.29) (-3.70) (-2.21) (-3.77) (-3.88) (-4.74) (-4.13) (-2.45) (-4.05)
IVOL -12.62 -19.97 -18.35 -8.07 -9.43 -10.78 -18.19 -16.70 -6.92 -7.75
(-3.21) (-6.32) (-5.95) (-2.35) (-3.08) (-2.77) (-5.84) (-5.49) (-2.00) (-2.51)
B/M 0.30 0.11 0.18 0.28 0.14 0.40 0.21 0.27 0.35 0.23

42
(3.72) (2.05) (3.19) (1.85) (1.03) (5.13) (3.96) (4.92) (2.30) (1.71)
SUE 0.26 0.25 0.24 0.18 0.24
(18.26) (17.70) (15.99) (8.91) (12.32)

Table 1.8: Fama-MacBeth regressions

This table presents the Fama-Macbeth estimates of monthly cross-sectional regressions. The dependent variable in the column 2 is the excess return, while the
dependent variable in columns 3 and 4 is the factor-filtered return using the Fama-French factors (FF3F). In columns 5 and 6, the dependent variable is the
filtered return using the FF3F along with the earnings momentum factor (PMN). Size represents the logarithm of market capitalization. B/M is the logarithm of
the book-to-market ratio. Price is the logarithm of the reciprocal of the share price. SUE represents the most recent standardized unexpected earnings. Amihud is
defined as average daily absolute return divided by dollar trading volume over the past year. RET2-3, RET4-6, and RET7-12 are the cumulative returns over the
second through third, fourth through sixth, and seventh through twelfth months prior to the current month, respectively. Reversal is the previous month’s return.
IVOL is the standard deviation of the error terms obtained by regressing the prior month’s daily returns on the FF3F. Columns 6 to 10 are similar to columns 1
to 5 except columns 6 to 10 include the most recent SUE in the regressions. The figures in the column labeled “Raw” are the standard Fama-MacBeth
coefficients, while the coefficients labeled “Purged” are the intercept term obtained by regressing the time series of coefficients on the factors. Panels B and D
apply adjusted returns in the regressions to account for ex-post earnings shocks. The sample period is from January 1972 to December 2008. All coefficients are
multiplied by 100. The t-statistics are in parentheses.
42 Continued
 Table 1.8 Continued
Panel B: Base case regression (adjusting for post-formation earnings shocks)

Adjusted Excess Adjusted Excess Adjusted Excess

Adjusted Adjusted Excess return Adjusted
return return return
excess filtered by excess
filtered by filtered by filtered by
Return FF3F Return
FF3F and PMN FF3F FF3F and PMN

Raw Purged Raw Purged Raw Raw Purged Raw Purged Raw
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Size -0.13 -0.12 -0.10 -0.13 -0.18 -0.14 -0.13 -0.11 -0.14 -0.19
(-3.83) (-4.89) (-4.17) (-2.85) (-4.45) (-4.18) (-5.37) (-4.61) (-3.13) (-4.76)
IVOL -8.07 -15.10 -13.50 -4.08 -5.43 -6.38 -13.46 -11.98 -3.01 -3.88

43
(-2.19) (-5.08) (-4.64) (-1.30) (-1.94) (-1.74) (-4.60) (-4.18) (-0.96) (-1.39)
B/M 0.21 0.04 0.10 0.19 0.08 0.31 0.13 0.18 0.26 0.16
(2.89) (0.77) (1.97) (1.61) (0.75) (4.27) (2.67) (3.66) (2.12) (1.53)
SUE 0.24 0.24 0.22 0.17 0.22
(18.32) (18.03) (16.07) (9.46) (12.73)

Continued

43
 Table 1.8 Continued
Panel C: Full specification (without adjusting for post-formation earnings shocks)

Excess return Excess return Excess return Excess return

Excess return filtered by filtered by Excess return filtered by filtered by
FF3F FF3F and PMN FF3F FF3F and PMN

Raw Purged Raw Purged Raw Raw Purged Raw Purged Raw
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Size -0.05 -0.11 -0.08 -0.01 0.01 -0.05 -0.12 -0.09 -0.02 0.01
(-1.44) (-4.07) (-2.99) (-0.14) (0.25) (-1.64) (-4.30) (-3.22) (-0.22) (0.15)
IVOL -10.51 -11.67 -10.86 -7.70 -7.93 -9.27 -10.49 -9.68 -6.78 -6.74
(-3.76) (-4.74) (-4.45) (-2.20) (-2.51) (-3.34) (-4.33) (-4.01) (-1.95) (-2.15)
B/M 0.26 0.10 0.16 0.20 0.08 0.36 0.20 0.26 0.28 0.18
(3.98) (2.35) (3.71) (1.18) (0.56) (5.58) (4.52) (5.82) (1.67) (1.22)
Price 0.16 -0.10 -0.06 0.25 0.43 0.20 -0.06 -0.02 0.29 0.47
(1.68) (-1.13) (-0.72) (0.97) (1.86) (2.11) (-0.66) (-0.25) (1.10) (2.03)

44
Amihud 0.13 0.14 0.13 0.16 0.13 0.11 0.12 0.12 0.14 0.12
(4.48) (5.03) (5.12) (4.95) (4.76) (3.98) (4.51) (4.60) (4.60) (4.30)
Reversal -5.11 -5.58 -5.54 -5.64 -5.36 -5.06 -5.51 -5.48 -5.59 -5.30
(-13.85) (-12.31) (-12.60) (-8.67) (-9.34) (-13.80) (-12.21) (-12.53) (-8.63) (-9.26)
RET2-3 -0.87 -1.42 -1.76 -2.07 -1.59 -1.35 -1.90 -2.23 -2.47 -2.05
(-2.97) (-4.18) (-5.16) (-5.30) (-4.40) (-4.56) (-5.60) (-6.54) (-6.25) (-5.68)
RET4-6 0.83 0.57 0.39 0.27 1.50 0.35 0.10 -0.07 -0.13 1.03
(4.07) (2.63) (1.77) (0.22) (1.40) (1.72) (0.44) (-0.33) (-0.11) (0.97)
RET7-12 1.00 0.72 0.58 0.34 0.58 0.67 0.40 0.27 0.07 0.26
(7.23) (4.63) (3.61) (1.19) (2.21) (4.91) (2.59) (1.67) (0.24) (1.00)
SUE 0.29 0.29 0.28 0.24 0.28
(23.89) (23.64) (23.56) (18.43) (22.51)

44
Continued
 Table 1.8 Continued
Panel D: Full specification (adjusting for post-formation earnings shocks)

Adjusted Excess Adjusted Excess Adjusted Excess

Adjusted Adjusted Excess return Adjusted
return return return
excess filtered by excess
filtered by filtered by filtered by
Return FF3F Return
FF3F and PMN FF3F FF3F and PMN
Raw Purged Raw Purged Raw Raw Purged Raw Purged Raw
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Size -0.03 -0.09 -0.06 0.01 0.03 -0.03 -0.09 -0.06 0.00 0.02
(-0.83) (-3.29) (-2.26) (0.15) (0.54) (-1.04) (-3.53) (-2.50) (0.05) (0.43)
IVOL -7.61 -8.94 -8.04 -5.98 -5.83 -6.47 -7.87 -6.96 -5.12 -4.73
(-2.89) (-3.87) (-3.49) (-2.03) (-2.18) (-2.47) (-3.44) (-3.04) (-1.75) (-1.78)
B/M 0.17 0.04 0.09 0.12 0.03 0.26 0.12 0.18 0.19 0.12
(2.96) (0.85) (2.17) (0.84) (0.24) (4.54) (2.97) (4.23) (1.39) (0.97)
Price 0.24 0.00 0.03 0.34 0.49 0.28 0.04 0.07 0.37 0.52

45
(2.63) (0.03) (0.37) (1.53) (2.44) (3.04) (0.47) (0.80) (1.66) (2.61)
Amihud 0.10 0.10 0.10 0.13 0.10 0.08 0.09 0.09 0.11 0.09
(3.58) (4.02) (4.12) (4.14) (3.71) (3.09) (3.51) (3.62) (3.80) (3.27)
Reversal -4.64 -5.02 -5.02 -5.03 -4.87 -4.59 -4.96 -4.96 -4.98 -4.81
(-13.17) (-12.32) (-12.71) (-8.51) (-9.35) (-13.10) (-12.21) (-12.62) (-8.46) (-9.25)
RET2-3 -0.73 -1.20 -1.51 -1.87 -1.33 -1.16 -1.64 -1.93 -2.22 -1.76
(-2.61) (-3.94) (-4.90) (-5.44) (-4.14) (-4.14) (-5.37) (-6.28) (-6.40) (-5.45)
RET4-6 0.91 0.66 0.49 0.31 1.43 0.48 0.23 0.07 -0.05 1.01
(4.86) (3.35) (2.44) (0.32) (1.64) (2.54) (1.16) (0.35) (-0.05) (1.16)
RET7-12 0.96 0.75 0.62 0.41 0.63 0.67 0.46 0.33 0.16 0.35
(7.55) (5.34) (4.23) (1.76) (2.95) (5.26) (3.27) (2.28) (0.69) (1.61)
SUE 0.26 0.26 0.26 0.22 0.26
45 (23.56) (23.53) (23.19) (18.06) (21.89)
month is regressed on the firm characteristics. I implement several controls for the

earnings momentum effect and post-formation earnings shocks.

To control for post-formation earnings shocks, adjusted returns, instead of raw

returns, are used in the regressions. To be consistent with previous sections, I use three

approaches to control for the earnings momentum effect associated with pre-formation

earnings shocks. First, I include the most recent SUE as a control variable in the

regressions. The results are essentially unchanged when the most recent CAR, as defined

in section 1.2, is used. Second, in the FM regressions, I follow Brennan, Chordia, and

Subrahmanyam (1998) methodology to control for exposure to the earnings momentum

factor. Third, to ensure that the earnings momentum effect is adequately accounted for, I

combine the first and second methods. Two factor models, the FF3F model and the

FF3F_PMN model, are employed to adjust returns for their exposure to risk factors. I

begin by estimating the factor loadings for each year from 1972 to 2008 for all of the

securities in my sample over the preceding 60 months. The factor-model filtered return is:

(realized excess return - realized factor return x estimated factor loading). These filtered

returns are then used as the left-hand-side variable and are regressed on a set of firm

characteristics21. In order to address the possible biases in the standard FM estimators

from using these filtered returns, I follow Black, Jensen, and Scholes (1972), Chordia and

21
See Chordia and Shivakumar (2006) for details.
46
Shivakumar (2006), and Hou and Van Dijk (2012) to construct the “purged” estimator22

for each regressors when filtered returns are used in FM regression.

The regression results are presented in Table 1.8. Specification (1) of panel A

confirms the standard results found in the literature – average returns are negatively

related to IVOL. The estimated coefficient on IVOL is -12.62%, which implies a

difference in monthly returns between the lowest quintile, which has an average IVOL of

0.94%, and the highest quintile, which has an average IVOL of 5.46% (Table 1.1), of -57

basis points. The difference in returns is lower than the results reported in Table 1.1. This

is not surprising because FM regressions minimize least squares, which tends to put more

weight on smaller stocks. Furthermore, it is well known that IVOL effect is weaker

among low-price stocks.23 Nevertheless, IVOL is highly significant with a t-statistic

of -3.21. Specifications (2) and (3) present results with risk-adjusted returns using the

FF3F model. Consistent with prior results, the IVOL effect becomes even stronger after

controlling for the FF3F.

One way to control for the earnings momentum effect is to include the most recent

SUE in the regressions. Specifications (6) to (8) of panel A report the same set of

regressions as those reported in specifications (1) to (3) except specifications (6) to (8)

add the most recent SUE as an additional regressor. The FM and purged estimators on

22
While the factor loadings are estimated with errors, these errors affect only the dependent variable,
filtered returns. However, if the errors in the estimated factor loadings are correlated with the security’s
characteristics, the monthly estimates of the coefficients will be correlated with the factor realizations and
the FM estimators will be biased by an amount that depends upon the mean factor realizations. Therefore,
the purged estimator is obtained for each of the characteristics as the constant term from the regression of
the monthly coefficient estimates on the time-series of the factor realizations. This estimator, which was
first developed by Black et al. (1972), purges the monthly estimates of the factor-dependent component.
23
See Bali and Cakici (2008).
47
IVOL are always lower when SUE is included in the regressions. For example,

specification (6) shows that the inclusion of SUE in the regression reduces the FM

estimator on IVOL to -10.78% (t = -2.77) from -12.62% (t = -3.21).

Another way to account for the earnings momentum effect is to control for exposure

to the earnings momentum factor. Specifications (4) and (5) use the FF3F_PMN model to

adjust returns. Consistent with the results from the previous sections, the IVOL effect is

considerably weakened. The purged estimator shows that the coefficient on IVOL is -

8.07% with a t-statistic of -2.35. This magnitude of the coefficient is considerably smaller

than that estimated using either raw returns (-12.62%) or FF3F-filtered returns (-19.97%).

Lastly, to ensure that the earnings momentum effect is adequately accounted for, I not

only filter returns with the FF3F_PMN model but I also include SUE in the regression.

Specifications (9) and (10) report the results. The purged estimator on IVOL is -6.92%

with a t-statistic of -2.00. Thus, filtering returns with the FF3F_PMN model and

including the most recent SUE in the regression seems to allow for more adequate control

for the earnings momentum effect in the FM regressions.

The results in section 1.5 and 1.6 show that post-formation earnings shocks are also

important in explaining the IVOL discount. Panel B of Table 1.8 uses returns adjusted for

post-formation earnings shocks in the regression. Consistent with the previous results, I

find that using adjusted returns in the regression reduces the FM estimator on IVOL from

-12.62% (t = -3.21; panel A, specification (1)) to -8.07% (t = -2.19; panel B, specification

48
(1)). Similar reductions in the estimators and t-statistics are observed in specifications (2)

and (3), which show the results of adjusted returns after controlling for the FF3F model.

The last two specifications of panel B report the results when I filter adjusted returns

using the FF3F_PMN model and include the most recent SUE in the regressions. The

purged estimator on IVOL is -3.01% with a t-statistic of -0.96, which implies that the

average return spread between the extreme IVOL quintiles is only -13.61 basis points per

month (-3.01% x 4.52% of IVOL spread between extreme IVOL quintiles).

Panels C and D of Table 1.8 present a similar analysis except that they include

additional control variables: lag monthly return (Reversal) to control for Jegadessh

(1990) one-month reversal effect, momentum measures (RET2-3, RET4-6, and RET7-

12), last month’s share price (Price), and a liquidity measure (Amihud (2002)). The

results are similar to those in panel A and B. In sum, the results in this section confirm

my previous findings that both pre- and post-formation earnings shocks are important in

explaining the IVOL discount.

1.8 Conclusion

A robust, negative cross-section relation between idiosyncratic volatility and future

stock returns has been documented in the finance literature. However, little is known

about the relation between earnings performance and IVOL, or, more importantly, how

the relation between earnings shocks and IVOL may affect the returns of high and low

IVOL stocks. This paper addresses these questions.

49
 In this paper, I find that high IVOL stocks suffer severe negative pre- and post-

formation earnings shocks. To control for the well documented earnings momentum

effect associated with the pre-formation earnings shocks, I double sort stocks by SUE, a

proxy for pre-formation earnings shocks, and IVOL and find that earnings momentum

accounts for approximately 40% of the IVOL discount. Similar reduction is also found by

controlling the earnings momentum factor proposed by Chordia and Shivakumar (2006).

In addition to the pre-formation earnings shocks, I also find that post-formation earnings

shocks play an important role in explaining the IVOL discount. Specifically, removing

three-day returns surrounding post-formation earnings announcements reduces the IVOL

discount by 28 basis points. This is a sizable reduction considering there are only 22

trading days per month. Furthermore, using ICC, a proxy for ex-ante expected returns, I

find a reliable positive relation between IVOL and ICC. This finding supports the

explanation that high IVOL stocks consistently experience negative post-formation

earnings shocks that cause their realized returns to appear lower than their expected

returns. Finally, combining pre- and post-formation earnings shocks reduces the IVOL

discount from -1.11% (t = -3.13) to -0.10% (t = -0.48) per month. My results highlight

the importance of earnings shocks for understanding the predictability in the cross-

section of stock returns.

50
 Chapter 2: Microstructure Bias, Illiquidity, and the Cross-Section of Expected
Stock Returns

2.1 Introduction

In this paper, we propose a parsimonious measure to characterize the severity of the

microstructure bias at the individual stock level and assess the impact of this

microstructure induced illiquidity on cross-sectional return predictability. A substantial

literature considers the effects of liquidity and liquidity risk on asset pricing, especially

after the recent world-wide financial crisis. For instance, Pastor and Stambaugh (2003),

Acharya and Pedersen (2005), and Lee (2011) find that sensitivity to market liquidity is

priced, while Amihud and Mendelson (1986), Brennan and Subrahmanyam (1996),

Brennan, Chordia, and Subrahmanyam (1998), Amihud (2002), and Liu (2006) document

a positive return premium for a stock’s illiquidity. These findings are consistent with the

idea that illiquidity is both costly and risky to investors.

Our measure of illiquidity can be motivated by Blume and Stambaugh (1983);

specifically, they show that zero-mean noise in prices leads to strictly positive bias in

individual securities’ average return. The upward bias is due to pricing noises at the

51
 ̂
beginning of the holding period in the denominator of the return equation24, ( ̂
)

( ) { }. Note that regardless of the holding

period n, it is always the Noise at t that causes the bias. We exploit this property in

constructing a “bias-free” measure for average return by dividing a two-period observed

total return by a one-period observed total return. The intuition is similar to that for

deriving implied future single-period spot rates from two-period rates. In our

methodology, both the numerator and denominator start at the same time. Because they

have the same amount of bias, it cancels out, leaving a consistent estimate of average

return.

To operationalize our idea in constructing the bias measure, we first compute simple

(arithmetic) average daily return for each firm using prior year’s daily returns data.

Second, also using prior year’s daily returns data, we construct the consistent estimate of

average return mentioned in the previous paragraph. Finally, the difference between the

arithmetic average and our consistent estimate of average return is our bias measure. This

measure is likely to capture the severity of microstructure noise, since arithmetic average

return is generally upward biased due to the microstructure noise, while our measure of

average return is not. It is important to note that our bias measure captures microstructure

bias due to any transient noises (such as bid-ask bounce, non-synchronous trading, orders

originating with uninformed traders, and temporary “price pressure” from large orders).

The main advantage of our measure is that it is very simple and requires only daily

return data to construct; therefore, it avoids utilizing variables that may not be available
24
Also see Blume and Stambaugh (1983).
52
under certain circumstances. For instance, liquidity proxies like Amihud’s (2002)

illiquidity measure, dollar volume, and share turnover require data on trading volume.

Our measure can therefore be applied in settings such as emerging markets or Over-the-

counter market, where the quality or availability of volume data may be suspect (see, for

example, Bekaert, Harvey, and Lundblad (2007)), and for comparisons across markets

such as the NYSE and NASDAQ, where volume measures may not be comparable.

To establish our measure, we first sort firms into 10 portfolios based on our bias

measure and study the average firm characteristics across these portfolios. As expected,

we find that firms with the largest microstructure bias are low priced, small, and volatile.

In addition, we investigate the cross-sectional correlation between our bias measure with

other liquidity variables commonly used in the literature and find that our bias measure is

highly correlated with Amihud’s (2002) illiquidity measure, bid-ask spread estimator

(CS) from Corwin and Shultz (2011), Zero Return Proportion (ZP) measure from

Lesmond, Ogden, Trzcinka’s (1999), dollar volume, share turnover, and bid-ask spread

used in Amihud and Mendelson (1986) and Brennan, Chordia, and Subrahmanyam

(1998), and Updated Gibbs Estimates (C) used in Hasbrouck (2009). Lastly, we construct

the market-wide average bias measure, and by examining the time-series property of this

measure, we see that bias displays considerable variation over time. For instance, the

recessions of 1974 to 1975 and 1990 to 1991, the tech bubble of the late 1990s, and the

financial crisis of 2007-2009 are clearly visible. These results suggest that our bias

measure indeed captures liquidity.

53
 Using our bias measure, we assess whether microstructure induced illiquidity have a

significant influence on the cross-section of expected returns. Firms with the largest bias

(10th decile) only comprise less than 0.56% of the market, yet capture a great deal of

cross-sectional variation in returns. Specifically, on a value-weighted basis, we find that

stocks with the largest bias command a return premium as large as 9.61% per year, even

after controlling for the premiums associated with size, book-to-market equity,

momentum, and traditional liquidity price impact and cost measures. The bias premium

can reach as high as 17.18% per year when stocks are weighted equally. These results are

confirmed for a number of specifications, return adjustments, and subsamples. In addition

to the promising unconditional return predictability, we also find that the bias premium is

much larger among small, volatile, and value stocks and is predominant among worst

past performing stocks and long term losers. For instance, on a value-weighted basis, the

bias premium is 0.97% per month among the smallest quintile of stocks, 2.56% among

the stocks with highest idiosyncratic volatility, 0.95% among value stocks, 1.84% among

stocks with lowest prior 12-month return, and 0.89% among long term losers. These

conditional bias premiums are generally significantly higher when stocks are weighted

equally. These findings are consistent with the consensus that illiquidity is more of a

problem among small, value, volatile, and price momentum losers.

Although our bias measure does not appear to be subsumed by a variety of

characteristics known to explain average returns, it is interesting to examine the

interaction between bias and these characteristics for determining the cross-section of

returns. We find that the premiums associated with size, reversal, intermediate-term price

54
momentum, and book-to-market equity are largely contained among most biased stocks.

For instance, small firms outperform large firms by as much as 1.77% per month among

the most biased firms, while this returns difference is only 0.41% among the least biased

firms. Similarly, the premiums associated with book-to-market equity, prior month’s

return, and intermediate-term price momentum are at least 0.55% higher among the most

biased stocks than those among the least biased stocks. Interestingly, the price

momentum profit and the IVOL discount are monotonically decreasing in bias. Finally,

the premiums associated with Amihud, CS, ZP, dollar volume, share turnover, bid-ask

spread, and C reside almost exclusively among the most biased stocks. On a value

weighted basis, for instance, the premium associated with Amihud is approximately

1.26% per month among the most biased stocks, while that is only 0.18% among stocks

with the smallest bias. Similar pattern in return premiums can also be observed for other

liquidity variables mentioned earlier.

Moreover, we employ Fama-MacBeth (1983) regression analysis to conduct a

thorough investigation of the robustness of our measure by taking other commonly

adopted liquidity measures into considerations. Specifically, in addition to the standard

control variables such as size, book-to-market, idiosyncratic volatility, share price, prior

month stock return, and price momentum, we also include liquidity proxies that are

extensively used in the literature in our regression analysis. The results from Fama-

MacBeth regressions confirm that our bias measure cannot be subsumed by other

liquidity proxies. In fact, the results suggest that our bias measure is a stronger cross-

section returns predicator than most of the other liquidity variables.

55
 Lastly, using UK stocks data, we find that the bias measure is the only liquidity proxy

(other proxies include ZP, Amihud, BIDASK, and CS) that uncovers a consistent

liquidity premium in the cross-section of stock returns.

The remainder of the paper is organized as follows. Section 2.2 introduces a simple

model to illustrate and motivate our bias measure. Section 2.3 introduces the data, and the

construction of our bias measure using daily returns data. Section 2.4 presents the

summary statistics on bias sorted portfolios, and the correlations between our bias

measure and other liquidity proxies. Section 2.5 and 2.6 quantify the pricing impact of

our bias measure in the cross-section of stock returns using portfolio sort and Fama-

Macbeth regression, respectively. Section 2.7 studies the interaction between our bias

measure and other firm characteristics that are known to explain cross-section of stock

returns. Section 2.8 demonstrates our measure using stock data from the UK. Section 2.9

concludes.

2.2 Simple model

In this section, we present a simple model to demonstrate the effectiveness of our

measure in capturing microstructure induced bias in computed returns. The setup of our

model largely follows that in Blume and Stambaugh (1983). Specifically, observed stock

price is modeled as

̂ ( ) (1)

56
Where ̂ is the observed closing price for firm i at time t which can deviate from the

true price, . is independently distributed across t with mean zero, and it is

independent of for all . Note the variable, , in this setup can capture different

microstructure noises in observed prices such as, noises due to “bid-ask bounce”, non-

synchronous trading, orders originating with uninformed traders, and temporary “price

pressure” from large orders.

The true return for security i for period t is defined as

(2)

The computed return is, using (1), defined as

̂ ( )
̂ ̂ ( )
(3)

Combining (2) and (3) yields

̂ [ ] (4)

Taking expectation of both sides of (4) gives

{ ̂ } { }[ { }] (5)

By Taylor series

{ } { } (6)

Substituting (6) into (5)

[ { ̂ }] [ { }] [ { }]

If we ignore the cross product term, then equation (7) becomes

[ { ̂ }] { } { } (8)
57
Hence, the upward bias in computed returns induced by bid-ask spread is approximately

equal to the variance of the noise.

To illustrate the effectiveness of our measure in removing this upward bias, define two-

period holding gross return, [ { }], as

[ { }] [ { }][ { }] (9)

Then25

[ { }]
[ { }] [
(10)
{ }]

We note that observed two-period holding gross return is

̂ ( )
̂ ̂ ( )
(11)

Taking expectation of (11) yields,

[ { ̂ }] [ { }] [ { }] (12)

Similarly, the lagged observed one-period holding gross return ending at time t-1 is

[ { ̂ }] [ { }] [ { }] (13)

Dividing equation (12) by equation (13) yields

[ ][ { }]
[ { ̂ }] { } [ { }]
[
[ { }] (14)
{ ̂ }] [ { }]
[ ][ { }]
{ }

Thus, dividing the observed two-period holding gross return by the observed lagged one-

period holding gross return gives a consistent estimate of one-period holding gross return.

To understand this, recall that both observed two-period return and observed lagged one

25
Assume daily returns are independently distributed.
58
return share the same noise, , in their denominator, and this is exactly the noise that

gives rise to the bias, { }; therefore, dividing these two returns effectively

“cancel out” this commonly shared noise. Hence, the difference between equation (8) and

(14) captures the magnitude of the upward bias, specifically

[ { ̂ }]
[ { ̂ }] [
[ { }] { } [ { }] { } (15)
{ ̂ }]

To operationalize this empirically, we define the sample analog of (15) as

∑ ( ̂ )( ̂ )
∑ ( ̂ ) ( ) (16)
∑ ( ̂ )

The first term on the right hand side of equation (16) is the simple average daily gross

returns for firm i estimated using previous N days of data, and it is also the sample

equivalent of first term in (15). On the other hand, the numerator of the second term is the

average two-day buy-and-hold gross returns, while the denominator is the lagged average

daily gross returns; hence, this ratio serves as the sample equivalent for the second term

in (15). Thus, as suggested by (15), B asymptotically becomes σ2 {δi t-1}. Notice that the

only input that is needed to compute the bias measure, B, is firm level daily returns data.

2.3 Data and the construction of bias measure

Our sample employs every listed security (AMEX/NYSE/NASDAQ) on the Center

for Research in Security Prices (CRSP) data files with sharecodes 10 or 11 from July,

1963, to December, 2008. To operationalize the bias measure empirically, we construct

the bias measure in equation (16) using past daily returns data. To balance between the

accuracy of our bias measure and the need of long time series of daily returns data, we

59
use previous 1 year of daily returns to estimate B (N approximately equals 250).

However, we conduct a series of robustness check to vary N and our results are largely

unchanged26.

The intuition behind why Bi,t is likely to capture severity of microstructure biases in

observed returns is simple. Specifically, the first term in Bi,t in equation (16) is the

arithmetic average daily returns, and it is well known that the arithmetic average daily

returns are upward bias and the bias is caused by microstructure biases (e.g. Blume and

Stambaugh (1983)). In addition, Section 2.2 shows that the second term in Bi,t produces a

consistent estimate of the mean daily gross return. Hence, we can interpret Bi,t as an

estimate of the upward bias in computed returns caused by microstructure noises.

To study the liquidity impact implied by our bias measure, Bi,t , we obtain overall

“market” returns, returns to the Fama and French (1993) “HML” and “SMB” factors, and

returns to the Carhart (1997) “WML” factor from Kenneth French’s website to conduct

asset pricing tests. For some our tests, we also obtain Pastor and Stambaugh (2003)

aggregate liquidity risk factor-mimicking portfolio returns from CRSP and Easley,

Hvidkjaer, and O’Hara’s (2002) probability of informed trading (PIN) factor-mimicking

portfolio returns from Soeren Hvidkjaer’s website. Furthermore, we are interested in

studying how our bias measure interacts with other firm-level characteristics, and we also

want to ensure that our bias measure does not simply proxy for existing liquidity

variables; therefore, we construct firm-level characteristics and liquidity variables and

control for their effects in most of our analysis.

26
Panel C of Table 2.2 reports the results using 6-month, 3-year, and 5-year past return data to estimate B.
60
  Size – Follow Fama and French (1992, 1993). Firm’s market equity for June of

year t to measure its size.

 BE/ME – Follow Fama and French (1993). Book value of equity is defined as

book value of stockholder’s equity plus balance sheet deferred taxes and

investment credits minus the book value of preferred stock. ME is market equity

for December of year t-1.

 IVOL – Ang et.al. (2006) idiosyncratic volatility measure. Standard deviation of

the Fama and French (1993) three-factor model using prior month’s daily returns

data.

 Ret-1:-1, Ret-36:-13, and Ret-12:-2 – Prior month’s return, cumulative return over the

past three years (skipping a year), and cumulative return over the past year

(skipping a month), respectively.

 Asset Growth – Total asset at the fiscal year end in t-1minus total asset at the

fiscal year end in t-2 divided by total asset at the fiscal year end in t-2.

 Turnover – Average daily number of shares traded divided by number of shares

outstanding from prior year.

 Accrual – Prior to 1988, accruals are calculated using the balance sheet method.

Starting in 1988, we use the cash flow method to calculate accruals.27

 Profitability – Equity income (income before extraordinary, minus dividends on

preferred, if available, plus income statement deferred taxes) in t-1 divided by

total asset for t-1.

27
Our results are robust to using the balance sheet method for the entire sample period.
61
  SUE – Standardized Unexpected earnings. Earnings current quarter less earnings

four quarters ago and standardized by the standard deviation of the earnings

changes over the prior eight quarters.

 Volume – Average daily dollar volume from prior year.

 BIDASK – Average daily from prior year.

 Amihud – Amihud’s (2002) illiquidity measure. Average daily absolute return

over daily dollar trading volume from prior year.

 CS – Corwin and Shultz (2011) spread estimate. We calculate their spread

estimates each month. Monthly spreads are defined as the average of all spreads

within the calendar month, negative spread estimates are set to zero, and we

require a minimum of 12 daily price ranges to calculate a monthly spread. CS is

then the 6-month average of the monthly spreads28.

 ZP – Lesmond, Ogden, and Trzcinka (1999) zero return measure. Number of days

with zero return divided by number of trading days over the prior year.

 C – Hasbrouck (2009) effective cost measure.

Note that Volume, BIDASK, Turnover, Amihud, Price, CS, ZP, and C can be viewed

as measures of liquidity. We conduct thorough analysis to demonstrate that our bias

measure conveys useful information with regards to liquidity even after controlling

for these liquidity proxies.

2.4 Characteristics of bias-sorted portfolios

28
We also use monthly spread instead of 6-month average spread. The results are essentially unchanged.
62
 Before proceeding to the impact of our bias measure on cross-section stock returns, it

is useful to examine the types of firms experiencing significant microstructure biases. To

accomplish this, at the end of each month t, we use previous 1-year daily return data

(including month t-1) to estimate the bias measure, B, and then we sort firms into 10

decile portfolios based on this measure. We require firms to have at least 50 observations

in estimating B to be included in this sample. Table 2.1 reports the average characteristics

of portfolios sorted into deciles based on their bias measure, B, over the 1963 July to

December 2008 period. Of particular interest are firms in decile 10, the portfolio with

largest microstructure bias. t-statistics on the difference in average characteristics across

extreme decile portfolios are reported as well as the time-series average of the cross-

sectional Pearson and Spearman rank correlations between each characteristic and the

bias measure.

As Table 2.1 indicates, the average bias measures across the 10 portfolios are

significantly different, although the increase in bias from decile 9 to 10 is the most

striking. Bias firms are small, value, volatile firms, with poor recent performance (both

returns and accounting performance). Hence, it will be important to take these into

account when we examine cross-section return predictability. Furthermore, Table 2.1 also

reports the average values for variables that could potentially proxy for liquidity. These

variables are Volume, BIDASK, Turnover, Share Price, Number of trading days,

Amihud, CS, ZP, and C.

Consistent with our idea, Table 2.1 indicates that large bias firms also tend to have

significantly lower dollar trading volume, larger bid-ask spread, lower share turnover,
63
 Panel A: Bias-Sorted decile portfolios, July 1966 to December 2008 t-statistics
1 2 3 4 5 6 7 8 9 10 (10-1) Pearson Rank
Firm Characteristics
Bias (%) -0.03 -0.01 -0.01 0.00 0.00 0.01 0.01 0.02 0.04 0.16 28.74
Bias_nzr_nzv (%) -0.03 -0.01 -0.01 0.00 0.00 0.01 0.01 0.02 0.05 0.19 25.93 0.98 0.99
Bias_nzv (%) -0.03 -0.01 -0.01 0.00 0.00 0.00 0.01 0.02 0.04 0.14 31.04 0.94 0.95
Size ($) 595.90 1,673.03 2,364.22 2,502.29 2,240.34 1,744.88 1,131.23 574.79 249.52 70.90 -20.03 -0.05 -0.35
BE/ME 0.86 0.82 0.83 0.84 0.86 0.89 0.94 1.03 1.18 1.53 16.03 0.16 0.18
IVOL (%) 2.93 2.13 1.87 1.80 1.85 2.01 2.29 2.70 3.42 5.51 23.22 0.43 0.28
Beta 1.23 1.06 0.99 0.95 0.93 0.92 0.91 0.89 0.89 0.84 -16.16 -0.03 -0.06
ret-1:-1(%) 1.78 1.24 1.13 1.05 1.02 0.98 0.89 0.92 0.94 1.47 -0.56 0.00 -0.03
30.86 19.74 16.34 14.53 13.78 12.75 11.43 10.10 7.85 1.93 -12.18 -0.12 -0.15

64
ret-12:-2 (%)
ret-36:-13 (%) 64.06 51.00 43.97 40.68 39.26 38.83 36.02 32.60 24.24 6.52 -17.57 -0.13 -0.19
Accrual (%) -2.42 -2.53 -2.62 -2.76 -2.78 -2.79 -2.34 -2.79 -2.70 -4.60 -7.07 -0.04 -0.04
Profitability (%) 1.38 5.46 6.22 6.33 6.08 5.47 4.72 3.06 1.11 -4.02 -11.18 -0.14 -0.18
Asset Growth (%) 26.52 19.86 17.07 15.70 15.68 16.05 18.36 17.00 16.06 10.70 -18.26 -0.06 -0.13
SUE 0.27 0.40 0.42 0.39 0.36 0.31 0.23 0.15 0.05 -0.02 -13.34 -0.04 -0.08

Table 2.1: Characteristics of bias-sorted portfolios

At the end of each month, stocks are ranked by their Bias measure (Bias) and sorted into deciles. Panel A reports the equal-weighted average characteristics of these
decile portfolios are computed over the following month from July of 1966 to December of 2008. First row of Panel B reports the monthly cross-sectional average of
number of firms listed on NYSE, AMEX, and NASDAQ with non-missing monthly return, while the second row reports the average number of firms that have at
least 50 non-missing daily returns from previous year.

Continued

64
 Table 2.1 Continued

Panel A: Bias-Sorted decile portfolios, July 1966 to December 2008 t-statistics

1 2 3 4 5 6 7 8 9 10 (10-1) Pearson Rank

Liquidity Variables
Volume ($) 3.92 7.56 9.01 9.26 8.39 6.88 5.01 2.95 1.30 0.38 -13.37 -0.07 -0.38
BIDASK (%) 2.60 2.08 1.92 1.89 1.95 2.16 2.54 3.19 4.30 7.49 22.10 0.51 0.36
Turnover (%) 0.42 0.31 0.27 0.26 0.25 0.25 0.24 0.22 0.20 0.18 -20.86 -0.14 -0.26
Amihud 0.19 0.09 0.08 0.08 0.09 0.13 0.21 0.42 0.97 5.11 21.09 0.55 0.40
Average price ($) 19.79 41.14 48.17 40.02 40.46 34.18 23.97 16.94 12.44 6.39 -30.12 -0.12 -0.39
Number of trading days 245.37 246.26 245.88 245.51 244.86 243.70 241.09 236.70 230.85 220.97 -29.18 -0.18 -0.27
CS 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.02 0.03 0.05 26.50 0.55 0.41
ZP (%) 15.34 14.43 14.57 15.05 15.85 16.99 18.64 20.65 23.16 28.26 23.43 0.33 0.39
C x 100 0.70 0.53 0.49 0.50 0.56 0.67 0.88 1.19 1.70 3.14 29.42 0.61 0.49

65
Panel B: Average number of firms per month in the sample

CRSP sample (Common equity on major exchanges with non-

5022
missing return)

At least 50 non missing observations in previous 1-year 4554

Percentage of firms perserved 91%

65
lower share price, and smaller number of trading days. To further demonstrate our bias

measure indeed captures liquidity, Table 2.1 shows that our bias measure is strongly

correlated with the other liquidity variables. For example, the rank correlation between

bias and Amihud is 0.40, while that is 0.41 between bias and CS. The weakest rank

correlation among the set of alternative liquidity proxies is with Turnover, but it is still -

0.26. These correlation coefficients are impressive in magnitude, but they also suggest

that our bias measure is not completely correlated with existing liquidity variables. To

reiterate, the characteristics associated with large bias firms suggest that our bias measure

does indeed capture liquidity effect, but importantly, the correlation coefficients suggest

that our bias measure is not simply a proxy for other existing liquidity variables.

Nevertheless, it is important to take these correlations into account when studying the

pricing impact of the bias measure.

To illustrate a potential use of the bias measure, Figure 2.1a (2.1b) plots the cross-

sectional average of bias measures for NYSE/AMEX (NASDAQ) stocks each year from

1966 to 2008. Examining the market-wide average, we see that average bias displays

considerable variation over time. Average bias remained relatively low in the late 1960s

through the early 1970s; however, the recessions of 1974 to 1975 and 1990 to 1991, the

tech bubble of the late 1990s, and the financial crisis of 2007-2009 are clearly visible.

These figures suggest that the bias measure seem to capture the important market-wide

liquidity events.

Our main bias measure utilizes all available daily price data from previous year

(average of bid-ask prices is used when closing price is missing). To mitigate the concern

66
that using non-traded closing price could underestimate the severity of microstructure

noise bias in estimating average returns, we construct two additional bias measures,

Bias_nzr_nzv and Bias_nzv, which use previous year daily returns data but excluding

days with zero return and zero volume and excluding days with zero volume,

respectively. First, we observe the magnitude of the bias is very similar for each portfolio

across different bias measures. For instance, the bias measures, Bias, Bias_nzr_nzv, and

Bias_nzv, for the tenth portfolio are 0.16, 0.19, and 0.14, respectively. Second, the

correlations between Bias and Bias_nzr_nzv (Bias_nzv) are well above 0.94. Thus, the

results here suggest that including non-traded prices and zero return days does not cause

severe problem to our analysis.29

2.5 Microstructure bias and the cross-section of expected returns

Table 2.2 reports the average returns of portfolios sorted on our bias measure. At the

end of each month, stocks are ranked by a measure of bias, sorted into deciles, and the

equal- and value-weighted monthly returns on the decile portfolios are computed over the

following month. Since Table 2.1 shows bias is correlated with other known determinants

of average returns, due to risk or other sources, we adjust returns using a characteristic-

based benchmark to account for return premiums associated with size, BE/ME, and

momentum (past one-year returns). The benchmark portfolio is based on an extension

29
CRSP reports bid-ask average when closing price is missing. To understand the impact of including non-
traded prices and zero return on our bias measure, consider two scenarios. First, Stock A and B experience
same amount of microstructure noise but A is always traded while B isn’t. Our bias measure would capture
the correct amount of bias for A, but since CRSP reports the bid-ask average for B, our measure could
potentially underestimate the bias for B because bid-ask average smoothed out the noises induced by
microstructure effects such as bid-ask bounce.
67
and variation of the matching procedure used in Daniel Grinblatt, Titman, and Wermers

(1997) and is motivated by Daniel and Titman’s (1997) finding that characteristics, rather

than estimated covariances, seem to better capture the cross-section of returns in the post-

1963 period. All CRSP-listed firms are first sorted each month into size quintiles, based

on NYSE quintile breakpoints, and then within each size quintile further sorted into

BE/ME quintiles using NYSE breakpoints. Stocks are then further sorted within each of

these 25 groupings into quintiles based on the firm’s past 12-month return, skipping the

most recent month (e.g., cumulative return from month t-12 to t-2) to capture the

momentum effect of Jegadeesh and Titman (1993). Within each of these 125 groupings,

we weight stocks both equally and by value, based on end-of-June market capitalization,

forming two sets of 125 benchmark portfolios. The value-weighted benchmarks are

employed for bias portfolios that are value weighted, and the equal-weighted benchmarks

are employed against equal-weighted portfolios. To form the size, BE/ME, and

momentum-hedged return for any stock, we simply subtract the return of the benchmark

portfolio to which that stock belongs from the return of the stock. The expected value of

this return is zero if size, book-to-market, and past-year return are the only attributes that

affect the cross-section of expected stock returns. Although there is no direct hedging of

beta risk, these hedged returns are close to having zero beta exposure [Grinblatt and

Moskowitz (2004)].

68
 4.5 1990-1991 recession
4

3.5

3 1974-1975
recessionn 2007-2009 Financial
Crisis
2.5

2 Tech Bubble
Bias
(Basis Point)
1.5

0.5 NYSE/AMEX

69
0
1966196819701972197419761978198019821984198619881990199219941996199820002002200420062008
-0.5

-1
Figure 2.1: Historical Bias estimates based on CRSP data
Bias measures are estimated for each stock each year by averaging bias estimates within the year across all firms. Figure 1a
plots the equal weighted average bias by year across stocks listed on NYSE/AMEX with at least 50 daily observations within
the year. Figure 1b plots the equal weighted average bias by year across stocks listed on NASDAQ with at least 50 daily
observations within the year.
Continued

69
 70
Bias
(Basis Point)
10
12
14

0
4
6
8

-4
-2

1973
1974
1975
1976
1977
1978
Figure 2.1 Continued

1979
1980
1981
1982
1983
1984
1985
1986
1987
1988

70
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007

NASDAQ
2.5.1 Bias measure constructed using past 1-year daily returns

We focus mainly on the bias measure constructed using past 1-year daily returns, but

report results for a variety of alternative bias measures constructed using different

horizons of daily returns in the next subsection. As the first row of panel A and panel B

of Table 2.2 shows, the monthly average raw returns spread between the highest and

lowest bias portfolios is a striking 126 basis points (t = 6.56) per month when stocks are

weighted equally and 78 basis points (t = 3.16) when value weighted, respectively. Since

the characteristics of firms in deciles 1 and 10 are very different, the characteristics-

adjusted returns in the second row of panel A and panel B could be more informative

about the relation between bias and average returns. The adjusted average returns of each

of the deciles are considerably lower, but the average spread between deciles 10 and 1

remains highly significant. The 95 (72) basis point spread in equal- (value-) weighted

portfolios after adjusting for size, BE/ME, and momentum premiums suggests a strong

relation between a firm’s illiquidity and its expected return. Although we adjust stock

returns according to their characteristics in most of our tests, but to ensure our

characteristic-adjustment procedure is robust, we regress monthly excess raw returns and

characteristic-adjusted returns of the 10-1 spread on the four-factor model proposed by

Carhart (1997). The last column in Table 2.2 reports the time series intercepts, alpha, of

these regressions. Our results remain largely unaffected by this specification. For

instance, the value-weighted 10-1 characteristic-adjusted four-factor alpha is 55 basis

points per month with a t-statistic of 3.34.

71
 Returns on Bias Portfolios

Decile (10-1)
1 2 3 4 5 6 7 8 9 10 (10-1)
Portfolio 4-factor Alpha

Panel A: Equal-weight
Raw returns 0.66 0.94 1.03 1.12 1.15 1.14 1.20 1.29 1.32 1.92 1.26 1.08
(1.80) (3.35) (4.23) (4.96) (5.29) (5.12) (5.09) (4.97) (4.37) (4.91) (6.56) (5.97)
Adjusted returns -0.42 -0.14 -0.08 0.00 0.01 -0.04 0.02 0.07 0.05 0.52 0.95 0.76
(-5.41) (-3.49) (-2.22) (-0.03) (0.18) (-0.94) (0.54) (2.04) (1.16) (5.06) (7.88) (6.42)

Panel B: Value-weight
Raw returns 0.38 0.81 0.79 0.87 0.87 0.86 0.88 0.89 0.89 1.16 0.78 0.61
(1.08) (3.11) (3.68) (4.25) (4.42) (4.21) (3.96) (3.47) (2.98) (3.23) (3.16) (2.66)
Adjusted returns -0.41 -0.02 -0.03 0.06 0.05 -0.01 -0.02 0.04 -0.05 0.31 0.72 0.55
(-3.98) (-0.32) (-0.71) (1.52) (1.31) (-0.15) (-0.26) (0.55) (-0.54) (2.23) (4.31) (3.34)

72
Table 2.2: Microstructure bias and the cross-section of expected stock returns
The equal- and value-weighted monthly returns (in %) of decile portfolios formed from various measures of Bias, their t-statistics (in
parentheses), and the difference in returns between decile portfolios 10 (largest bias) and 1 (smallest bias) are reported over the period July,
1966, to December, 2008. Raw and characteristic-adjusted returns of the bias-sorted decile portfolios are reported using characteristic-based
benchmarks to account for return premiums associated with size, book-to-market equity (BE/ME), and momentum. Panel A and B report the
equal- and value-weighted results, respectively. In addition, the last column in those two panels report the intercepts, alpha, from time-series
regressions of the spread in raw and characteristic-adjusted average returns between bias-sorted decile portfolios 10 and 1 on the Carhart
(1997) four-factor model (which adds a momentum factor to Fama-French factors). Using different time horizon to construct the bias
measure, 6-month, 3-year, and 5-year, the first three columns of Panel C report the equal- and value-weighted characteristic-adjusted spread
in returns between decile portfolios 10 and 1, respectively. The characteristic-adjusted spread is also reported for NYSE/AMEX and
NASDAQ stocks separately, for firms with share price above $1 and $5, for firms that are not categorized as micro cap and small cap (micro
cap is defined as firms below NYSE 20th percentile market capitalization, while the definition for small cap is below NYSE 50 th percentile
market capitalization), for the two subperiods, and excluding the month of January. In addition, Panel C also reports the intercepts, alpha,
from time-series regressions of the characteristic-adjusted spread on a five-factor model which adds the Pastor and Stambaugh (2003)
aggregate liquidity risk factor-mimicking portfolio to the Carhart (1997) four-factor model, and a six-factor model which adds Easley,
Hvidkjaer, and O’Hara’s (2002) probability of informed trading (PIN) factor-mimicking portfolio (available from July, 1984) to the other
factors.
72
Continued
 Table 2.2 Continued
Panel C: Robustness (Characteristics-adjusted returns). 10-1 spreads
Exclude
Exclude Micro 01/88 5-factor
NYSE/ Price Price 7/66 to Feb- 6-factor
NASDAQ Micro and to (Pastor and
AMEX ≥$1 ≥$5 12/87 Dec (PIN)
Cap Small 12/08 Stambaugh)
Cap
0.63 1.10 0.53 0.29 0.56 0.29 0.73 1.17 0.66 0.87 1.33
(4.78) (6.43) (5.05) (3.12) (5.97) (3.07) (5.28) (5.94) (5.78) (7.33) (6.33)
0.36 0.84 0.46 0.25 0.33 0.26 0.56 0.89 0.50 0.69 0.82

73
(2.36) (3.34) (3.08) (2.09) (2.54) (2.25) (3.34) (3.04) (3.16) (4.16) (2.70)

73
 Interestingly, the 10-1 spread derives primarily from the astounding performance of

decile 10. However, average return differences between deciles 9 and 1 and deciles 9 and

2 are also significant, though substantially weaker. In all cases, the long side or large bias

firms contribute a significant portion of the profit to this long-short strategy. This result is

in contrast with most long-short strategies where profits from the short side typically

comprise the bulk of the strategy’s profitability [e.g., momentum, see Grinblatt and

Moskowitz (2004)].

Our results are robust to other measures of bias, sub-period and subsample analysis,

and further adjustment in returns.

2.5.2 Alternative measures of microstructure bias

The first 3 columns of panel C reports characteristics-adjusted returns spread (10-1)

of portfolios sorted on bias measures constructed by using prior 6-month, 3-year, and 5-

year daily returns data. The value-weighted 10-1 characteristic-adjusted returns spread of

the bias-sorted portfolios using prior 6-month, 3-year, and 5-year daily returns data are

0.44% (t = 2.57), 0.58% (t = 3.14), and 0.45% (t = 2.28), respectively. All of these

aresignificant at the 1% level. Not surprisingly, the 10-1 spreads are both more

economically and statistically significant under the equal-weight scheme.

2.5.3 Sub-samples

Columns 4 and 5 of panel C report the characteristic-adjusted returns spread of bias-

sorted portfolios for NYSE/AMEX and NASDASQ stocks separately. Profits are

significant in both NYSE/AMEX and NASDAQ firms. The higher profits for NASDAQ
74
seem to be because of the smaller firms. Furthermore, the next four columns show that if

we restrict the sample to stocks with prior month’s share price greater or equal to $1 and

$5, market capitalizations greater than the 20th and 50th percentile of NYSE market

capitalization (following Fama and French (2011)), the trading strategy profits are

reduced considerably, but remain significant. For instance, removing firms with less than

$1 prior month’s share price ($5 prior month’s share price, below 20th percentile of

NYSE market cap, below 50th percentile of NYSE market cap) reduces profits by

approximately one third (two thirds, one half, two thirds). This reduction is consistent,

however, with market illiquidity’s predicted effect on the cross-section of returns. That is,

the most illiquid firms are more likely to be low priced and small firms, since such firms

should have the largest impact on returns, consistent with these results.

2.5.4 Sub-periods

Columns 10 to 12 report the characteristic-adjusted returns spread of bias-sorted

portfolios for two sub-periods of equal length, and non-January months. Profits are

significant in both sub-periods of the sample, though higher in the second half of the

sample; this is likely due to the introduction of NADSAQ stocks in the second half of the

sample. Profit excluding the month of January are a little lower, but it is still highly

significant.

2.5.5 Further return adjustment

To control for exposures to aggregate liquidity risk factor, the last two columns of

Panel C report the alpha or intercepts, along with its t-statistic, from time-series
75
regressions of the characteristic-adjusted returns spread of bias sorted portfolios on a

five-factor model that adds Pastor and Stambaugh (2003) aggregate liquidity risk factor-

mimicking portfolio to the Carhart’s (1997) four-factor model and a six-factor model that

adds a factor-mimicking portfolio for the informed trader risk (PIN) identified by Easley,

Hvidkjaer, and O’Hara (2002) to these factors. The intercepts from these time-series

regressions are large and highly significant, even after essentially adjusting returns twice

using both the characteristic benchmarks and the factor models. Thus, inadequate risk

adjustment from the characteristic benchmarks does not seem to be driving the

profitability of these strategies.

2.6 Fama-MacBeth cross-sectional regressions

Table 2.3 examines the relation between bias and the cross-section of average returns

using Fama and MacBeth (1973) regressions. The regressions provide further robustness

of our results since they employ all securities without imposing breakpoints, allow for

more controls in returns, including other liquidity measures, and provide an alternative

weighting scheme for portfolios. The cross-section of stock returns in excess of the 1-

month T-bill rate each month is regressed on the firm characteristics of log of size

(market capitalization), log of BE/ME, the previous year’s return on the stock skipping

the most recent month, from month t − 12 to t − 2 (ret−12:−2), the previous three year’s

return on the stock skipping the most recent year, from month t −36 to t−13 (ret−36:−13),

and the bias measure. We include the previous month’s return on the stock ret−1:−1 as an

additional control for the one month reversal effect of Jegadeesh (1990).

76
 Liquidity Measures
NYSE
Nasdaq Turnover Volume Amihud BIDASK CS ZP C
/AMEX
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
log(size) 0.01 0.01 -0.05 0.14 0.00 0.06 0.02 0.04 -0.02 -0.02 0.00
(0.30) (0.20) (-1.52) (1.81) (-0.01) (0.85) (0.44) (1.07) (-0.54) (-0.48) (-0.13)
log(BE/ME) 0.27 0.25 0.23 0.29 0.23 0.23 0.24 0.22 0.22 0.25 0.23
(4.84) (4.65) (4.20) (4.34) (4.79) (4.81) (4.59) (4.58) (4.13) (5.20) (4.34)
ret-36:-13 -0.09 -0.09 -0.05 -0.08 -0.09 -0.09 -0.08 -0.10 -0.09 -0.10 -0.08
(-1.93) (-1.94) (-0.98) (-2.13) (-2.06) (-2.08) (-1.85) (-2.46) (-1.96) (-2.26) (-1.68)
ret-12:-2 0.76 0.76 0.86 0.62 0.78 0.79 0.76 0.78 0.82 0.77 0.84
(6.39) (6.45) (6.35) (5.87) (6.80) (6.93) (6.36) (6.81) (6.76) (6.97) (6.83)
ret-1:-1 -6.29 -6.22 -5.43 -5.37 -6.46 -6.50 -6.29 -6.38 -6.32 -6.33 -6.54
(-17.16) (-17.05) (-13.28) (-12.97) (-18.18) (-18.38) (-17.11) (-17.95) (-16.92) (-18.54) (-17.49)
Profitability 1.53 1.51 1.83 0.78 1.29 1.31 1.35 1.46 1.36 1.52 1.44
(6.19) (6.10) (6.02) (3.37) (4.96) (5.00) (5.05) (5.94) (5.13) (6.13) (5.22)
Asset Growth -0.26 -0.25 -0.27 -0.25 -0.24 -0.23 -0.24 -0.24 -0.24 -0.26 -0.27
(-4.84) (-4.66) (-3.81) (-4.39) (-3.89) (-3.84) (-3.76) (-4.62) (-3.84) (-4.95) (-4.14)
Accrual -0.95 -0.92 -1.03 -0.58 -0.96 -0.96 -0.97 -0.86 -1.04 -0.92 -1.05
(-6.30) (-6.10) (-4.84) (-2.57) (-6.12) (-6.10) (-6.04) (-5.78) (-6.37) (-6.21) (-6.45)
Log(price) -0.32 -0.29 -0.16 -0.41 -0.26 -0.25 -0.25 -0.32 -0.19 -0.29 -0.15
(-3.59) (-3.27) (-2.06) (-2.77) (-3.04) (-2.89) (-2.76) (-3.32) (-2.12) (-2.88) (-1.56)
IVOL -4.16 -6.95 -15.25 -2.78 -8.97 -8.74 -11.94 -3.39 -13.47 -6.52 -13.41
(-1.37) (-2.23) (-4.30) (-0.80) (-3.53) (-3.48) (-3.78) (-1.32) (-4.31) (-2.46) (-4.21)
Bias 4.58 7.18 2.46 5.04 5.05 4.44 4.65 5.61 4.59 4.48
(4.58) (5.72) (2.89) (5.35) (5.41) (4.79) (4.59) (6.07) (4.93) (4.43)
Nasdaq -0.16 -0.33 -0.88 -0.92 -0.88 -1.16 -0.71
(-0.26) (-0.12) (-2.32) (-0.88) (-1.99) (-1.51) (-2.05)
Liquidity
AMEX/NYSE -0.09 -0.06 30.06 -9.10 0.91 -1.04 18.31

(-1.51) (-0.96) (4.20) (-2.01) (0.22) (-1.45) (2.51)

Liquidty
NASDAQ -1.25 -0.06 48.66 16.75 12.40 2.20 25.55

(-1.51) (-0.20) (0.35) (0.71) (1.54) (1.13) (1.33)

Table 2.3: Fama-Macbeth Regressions
Results from Fama-MacBeth monthly cross-sectional regressions of stock returns in excess of the one-month T-bill rate on log
of firm size (market capitalization), log of the ratio of book-to-market equity (BE/ME), previous three year’s return (from month
t-36 to t-13), previous year’s return (from month t-12 to t-2), previous month’s return, profitability (equity income divided by
total asset), asset growth (change in total asset divided by total asset), accrual (Prior to 1988, accruals are calculated using the
balance sheet method as the change in non-cash current assets less the change in current liabilities excluding the change in short-
term debt and the change in taxes payable minus depreciation and the amortization expense. Starting in 1988, accruals are
calculated using the cash flow statement method as the difference between earnings and cash flows from operations), firm’s bias
measure, log of previous month’s share price, idiosyncratic volatility IVOL (standard deviation of the Fama-French three-factor
model’s residuals using previous month’s daily returns data), and a host liquidity variables are reported over the period July,
1966, to December, 2008. Liquidity variables include turnover (average daily number of shares traded divided by shares
outstanding over the past year), volume (average daily dollar trading volume over the past year), Amihud’s (2002) illiquidity
measure (average daily absolute return divided by dollar trading volume over the past year), average daily effective bid-ask
spread, average daily turnover (average daily number of shares traded divided by number of shares outstanding), Corwin and
Shultz (2011) spread estimate CS, zero return measure ZP (number of days with zero return divided by number of trading days
from previous year), Hasbrouck’s (2009) effective cost measure C, each defined separately for NYSE/AMEX and NASDAQ
traded firms. The time-series average of the coefficient estimates and their associated time-series t-statistics (in parentheses) are
reported in the style of Fama and MacBeth (1973).
77
Furthermore, Haugen and Baker (1996), Cohen, Gompers, and Vuolteenaho (2002) find

that more profitable firms have higher average stock returns, while Cooper, Gulen, and

Schill (2008) show that firms that invest more have lower stock returns; lastly, Sloan

(1996) finds that higher accruals predict lower stock returns. To account for their cross-

section returns predictability, we therefore also include Profitability, Asset Growth, and

Accrual in our regressions. Finally, we also include the log prior month closing price, as

well as IVOL in all regressions.

The first column of Table 2.3 confirms the standard results found in the literature that

average returns are negatively related to size, past three-year and one month returns,

Asset Growth, and Accrual, Share price, and IVOL and positively related to BE/ME, past

one-year returns, and Profitability. The second column adds the microstructure bias

measure, Bias, to the cross-sectional regression. Bias is strongly positively associated

with average returns, consistent with the previous decile portfolio results. The economic

significance of the bias coefficient is also in line with our previous results. Moving from

the lowest decile of bias, which has a bias measure of -0.03, to the highest decile, which

has a measure of 0.16 (Table 2.1), the coefficient on bias in Table 2.3 implies a difference

in returns between the two deciles of 87 basis points per month. This implied return

difference is slightly smaller than our equal-weighted result in Table 2.2 (1.26%), but it is

not surprising given all the control variables that are included in the regression.

Since Fama-MacBeth regressions minimize least squares which tends to put more

weight on small volatile stocks, specifications (3) and (4) split the sample into

NYSE/AMEX and Nasdaq to avoid the dominance of Nasdaq stocks (likely to be small
78
volatile stocks) in the overall sample. Surprisingly, the premium associated with bias is

more prominent among NYSE/AMEX stocks after controlling for firm-level

characteristics, but nevertheless, it is still highly significant even among the Nasdaq

stocks.

To ensure our bias measure is not simply a manifestation of previously studied

liquidity variables, the next seven columns of Table 2.3 report Fama-MacBeth regression

results adding various other measures of a stock’s liquidity. We employ seven sets of

liquidity variables commonly used in the literature: Turnover, Volume, Amihud,

BIDASK, CS, ZP, and C. Since reported volumes on NASDAQ include interdealer trades

(Which NYSE/AMEX do not), we measure these variables separately for NASDAQ and

NYSE/AMEX traded firms and include a NASDAQ exchange dummy in the regression.

As Table 2.3 shows, the premium from bias is robust to the inclusion of these

liquidity measures. The point estimate and statistical significance of the bias coefficient

declines slightly for all specifications (except when CS is included in the regression),

which is not surprising given the correlation between bias and these liquidity variables

from Table 2.1, but remains economically and statistically important. The negative

coefficients on turnover and volume are consistent with Amihud and Mendelson (1986)

and Brennan, Chordia, and Subrahmanyam (1998), the positive coefficient on Amihud’s

illiquidity measure is consistent with Amihud (2002), the positive coefficient on CS is

consistent with Corwin and Shultz (2011), the negative coefficient on ZP is consistent

79
with Lee (2011)30, and the positive coefficient on C is consistent with Asparouhova,

Bessembinder, and Kalcheva (2011). In untabulated results, we also include all of these 7

alternative liquidity proxies into one regression along with our bias measure, the

estimated coefficient on bias in that specification is 4.04 (t = 4.54). In addition, Amihud

is no longer significant in this specification.

Interestingly, not only does Table 2.3 show that our bias measure uncovers a liquidity

premium that is robust to the inclusion of other liquidity proxies, but it also shows that

most of the conventional liquidity proxies are unable to find consistent liquidity premium

in the cross-section of stock returns. For instance, specification (10) implies that a

NYSE/AMEX stock with higher proportion of zero return trading days (less liquid stock)

would have a lower expected return, ceteris paribus.

Furthermore, to ensure the illiquidity premium we uncovered is not due to upward

bias in measured stock returns induced by microstructure noises as discussed in

Asparouhova, Bessembinder, and Kalcheva (2011), we adopt the suggestion by

Asparouhova et. al. (2011)31 by use of a simple weighting procedure in the Fama-

MacBeth regression where each observed return is weighted by (one plus) the observed

return on the same security in the prior period. Consistent with Asparouhova et. al.

(2011), most of the estimated illiquidity premiums associated with different liquidity

proxies are lowered, including the premium associated with our bias measure, once the

30
Consistent with Asparouhova, Bessembinder, and Kalcheva (2011), we find that ZP is positively priced
in univariate Fama-MacBeth regression.
31
To save space, these results are not tabulated. Using the same specifications as in Table 2.3, the
coefficient on the bias measure is at least 3.83% with a t-statistic of 3.83 (Except specification (4) where
the bias coefficient is 1.96 with t-statistic of 2.26).
80
weighting scheme is adopted. Nevertheless, the point estimate associated with the bias

measure is still highly significant.

2.7 Interaction of bias with firm characteristics

Although bias does not appear to be subsumed by a variety of characteristics

known to explain average returns, it is interesting to examine the interaction between bias

and these characteristics for determining the cross-section of returns.

2.7.1 Bias premium across characteristics quintiles

Table 2.4 reports the bias premium, defined as the difference in returns between

the highest and lowest quintile of bias firms, within quintiles sorted on each of the

characteristics. This analysis provides another control for these firm characteristics in

addition to highlighting their interactions with bias. As Table 2.4 shows, when stocks are

weighted equally, the bias premium is 1.40% per month among the smallest quintile of

stocks while that is only 0.22% per month among the largest stocks. The bias premium

resides almost exclusively among the value stocks, worst past performing stocks, recent

and long-term losers, low accrual, poor profitability, and low asset growth firms, and is

predominant among high idiosyncratic volatility stocks. The bias measure itself is also

greater among such firms. The larger bias among losers is consistent with evidence of

slower information diffusion regarding negative news found in Hong, Lim, and Stein

(2000) and Hou (2007). We find similar results when we value weight stocks.

81
 Equal-weight Value-weight
Low 2 3 4 High Low 2 3 4 High
Firm Characteristics
Size 1.40 0.74 0.53 0.41 0.22 0.97 0.73 0.49 0.37 0.17
(5.89) (4.80) (4.14) (3.26) (1.98) (4.34) (4.79) (3.72) (2.83) (1.35)
BE/ME 0.59 0.29 0.31 0.37 1.31 0.29 -0.13 -0.02 0.26 0.95
(3.41) (2.24) (2.34) (2.63) (5.61) (1.19) (-0.68) (-0.11) (1.26) (2.81)
IVOL 0.16 0.23 0.44 0.72 2.29 0.18 0.09 0.45 0.53 2.56
(2.11) (2.34) (3.39) (4.25) (8.58) (1.38) (0.62) (2.42) (2.24) (6.23)
Ret-1:1 2.24 0.43 0.28 0.40 -0.04 1.75 0.00 -0.16 -0.13 -0.25
(8.94) (2.93) (2.20) (2.83) (-0.24) (4.94) (0.01) (-0.81) (-0.68) (-1.12)
Ret-12:2 2.06 0.80 0.69 0.51 0.58 1.84 0.38 0.22 -0.01 0.19
(7.48) (4.98) (5.90) (4.39) (4.16) (4.41) (1.73) (1.14) (-0.07) (1.03)
Ret-36:-13 1.12 0.64 0.36 0.37 0.32 0.89 0.30 0.08 0.21 0.22

82
(4.81) (4.06) (2.98) (2.96) (2.39) (2.71) (1.20) (0.43) (1.12) (1.14)
Accrual 1.33 0.70 0.74 0.71 0.74 0.77 0.55 0.30 0.18 0.52
(6.01) (4.01) (4.93) (4.05) (4.19) (2.63) (2.11) (1.46) (0.69) (1.88)
Profitability 1.62 0.74 0.49 0.38 0.41 1.34 0.42 0.14 -0.04 0.45
(6.74) (4.22) (3.69) (3.00) (3.12) (3.89) (1.42) (0.72) (-0.23) (2.18)
Asset Growth 1.32 0.63 0.40 0.32 0.60 0.86 0.24 0.33 0.12 0.28
(5.91) (4.04) (3.01) (2.26) (3.41) (2.81) (1.04) (1.71) (0.59) (1.23)
SUE 0.61 0.73 0.72 1.03 0.98 0.21 0.02 0.40 0.33 0.34
(2.88) (3.47) (3.56) (5.45) (5.70) (0.64) (0.06) (1.37) (1.26) (1.51)
Table 2.4: Bias premium across characteristic quintiles
Equal- and value-weighted average returns for double-sorted portfolios on various firm characteristics and Bias are
reported. Bias premium is defined as the difference in average returns between the highest and lowest quintile of
biased firms
Continued
82
 Table 2.4 Continued

Equal-weight Value-weight
Low 2 3 4 High Low 2 3 4 High
Liquidity Variables
Share Price 1.59 0.56 0.40 0.17 -0.04 1.50 0.63 0.40 0.42 -0.04
(6.67) (3.94) (2.92) (1.35) (-0.31) (3.76) (2.45) (2.26) (2.56) (-0.31)
Amihud 0.23 0.24 0.50 0.44 1.26 0.13 0.27 0.55 0.49 0.82
(1.86) (1.88) (3.95) (2.80) (4.89) (0.95) (1.86) (4.06) (2.80) (3.05)
Turnover 0.87 1.09 0.82 0.52 0.51 0.36 0.61 0.26 0.15 0.44
(4.37) (5.19) (3.74) (2.89) (3.16) (1.47) (2.36) (0.99) (0.74) (2.12)
BIDASK 0.22 0.49 0.70 0.71 1.43 0.22 0.38 0.27 0.56 1.29
(1.66) (4.29) (4.72) (4.01) (6.37) (1.31) (2.60) (1.36) (2.35) (4.66)

83
Volume 1.45 0.47 0.55 0.45 0.19 0.83 0.48 0.40 0.41 0.15
(5.43) (2.48) (3.52) (3.68) (1.33) (3.16) (2.33) (2.81) (2.86) (1.02)
ZP 0.34 0.38 0.68 0.92 1.11 0.23 0.38 0.51 0.52 0.59
(2.64) (3.03) (3.72) (4.76) (5.21) (1.31) (2.40) (2.15) (2.20) (2.43)
CS 0.01 0.27 0.67 0.77 1.95 0.02 0.21 0.44 0.67 1.89
(0.09) (2.46) (4.95) (4.90) (7.82) (0.12) (1.30) (2.25) (2.81) (5.03)
C 0.06 0.26 0.10 -0.05 1.15 0.08 0.36 0.02 -0.09 0.76
(0.66) (1.80) (0.71) (-0.36) (4.60) (0.55) (1.92) (0.10) (-0.41) (2.49)

83
 Furthermore, we also investigate how our bias measure interacts with other liquidity

proxies that are commonly used in the literature. Since we find similar results with both

equal- and value-weighting schemes, we will concentrate our discussions on the results

from the equal-weighting scheme. Consistent with our intuition, bias premium is

strongest among stocks with smaller share price, larger price impact (proxy by Amihud

and C), lower share turnover, higher bid-ask spread (proxy by BIDASK and CS), and

more zero return trading days. For instance, the bias premium is 1.50% per month among

the lowest priced stocks while that is -0.04% among the highest priced stocks. However,

it is important to point out that although the bias premium is more prominent among

more illiquid stocks according to the other liquidity proxies, but the premium does not

reside exclusively among those stocks. For example, the bias premium is not significant

only among stocks with the highest 40% share price (top two price quintiles), and this

changes to highest 20% share price when we look at the value weighting scheme.

Therefore, if one wants to eliminate illiquidity effect by doing a price-screen, then she

would need to remove 60%-80% of the stocks in her sample. Likewise, the bias premium

is 0.34% (t = 2.64) even among stocks with least zero trading days. Thus, the evidence

here suggests that although the bias measure is correlated with the existing liquidity

proxies, but it is not simply manifestation of these variables, and it appears to contain

different information than the alternative liquidity proxies.

84
2.7.2 Characteristics premiums across bias quintiles

Table 2.5 reports results from the reverse sort, where the unadjusted raw premium

associated with each of these characteristics is examined across bias quintiles. Since the

value-weighted results largely agree with the equal-weighted results, we focus our

discussion on the latter. The value premium is higher among biased stocks, as are the

premiums associated with size and prior month return. Interestingly, the IVOL discount

and the momentum profit are concentrated among the smallest biased stocks. This is,

however, consistent with previous findings in the literature. For instance, Bali and Cakici

(2008) and George and Hwang (2011) show that the IVOL discount is stronger among

higher priced stocks, and since bias measure is positively correlated with share price, it is

not surprising to see that the IVOL discount is stronger among the less biased stocks.

Furthermore, Hong, Lim, and Stein (2000) and Ang, Shtauber, and Tetlock (2011) show

that momentum profits do not exist among the smallest firms, and therefore, it is expected

that we do not observe momentum effect among the least biased stocks. In addition,

return discount associated with Accrual and Asset Growth and earnings momentum effect

(proxy by SUE) are stronger among biased stocks. However, we do not find consistent

evidence that high profitability firms exhibit higher returns than low profitability firms32.

Finally, we study the interaction of premiums associated with liquidity proxies that are

commonly used in the literature with our bias measure. Consistent with our proposition

that bias captures stock illiquidity, the premiums associated with share price, Amihud

32
Consistent with Fama and French (2006), we find that profitability is a strong cross-section returns
predicator in multivariate Fama-MacBeth regression where B/M is included as a control variable. See Table
2.3.
85
 Control for Unconditional t-stat
Bias Quintile Low 2 3 4 High
Bias Premium (difference)
Firm Characteristics
Size -0.59 -0.37 -0.33 -0.64 -1.92 -0.77 -0.82 -0.65
(-2.39) (-1.89) (-1.73) (-3.15) (-7.25) (-3.98) (-3.36)
BE/ME 1.10 0.65 0.76 1.12 1.79 1.08 1.29 5.25
(4.60) (3.94) (4.75) (5.70) (7.58) (6.16) (6.52)
IVOL -1.05 -0.30 -0.20 -0.33 0.40 -0.29 -0.13 2.03
(-3.37) (-1.28) (-0.82) (-1.22) (1.15) (-1.14) (-0.39)
Ret-1:1 -1.96 -1.03 -0.92 -1.28 -4.50 -1.93 -1.92 0.27
(-7.31) (-5.77) (-5.33) (-6.09) (-13.42) (-9.18) (-8.08)
Ret-12:2 1.54 1.33 1.05 0.97 0.10 1.00 0.96 -0.90
(5.12) (6.53) (4.99) (3.81) (0.28) (4.18) (3.56)
Ret-36:-13 -0.68 -0.21 -0.27 -0.65 -1.20 -0.59 -0.74 -2.47
(-3.01) (-1.36) (-1.84) (-3.71) (-4.09) (-3.42) (-3.38)
Accrual -0.15 -0.37 -0.28 -0.51 -0.56 -0.37 -0.37 0.12
(-1.03) (-3.64) (-2.74) (-4.40) (-3.31) (-4.30) (-3.84)

86
Profitability 0.19 0.11 0.14 -0.11 -0.53 -0.04 -0.17 -2.15
(0.78) (0.83) (1.04) (-0.59) (-1.94) (-0.25) (-0.80)
Asset Growth -1.01 -0.50 -0.53 -0.78 -1.30 -0.81 -1.00 -4.43
(-5.70) (-4.57) (-5.08) (-6.04) (-6.83) (-7.76) (-7.76)
SUE 1.74 1.19 1.29 1.43 2.11 1.51 1.46 -1.83
(10.19) (9.68) (11.27) (10.88) (14.93) (14.22) (11.79)
Table 2.5: Characteristic premium across bias quintiles
Equal-weighted average returns for double-sorted portfolios on various firm characteristics and Bias are reported.
Characteristic premium is defined as the difference in average returns between the highest and lowest quintile of
firms sorted by firm-characteristics.

Continued

86
 Table 2.5 Continued
Control for Unconditional t-stat
Bias Quintile Low 2 3 4 High
Bias Premium (difference)
Liquidity Variables
Share Price -0.09 -0.13 -0.15 -0.48 -2.52 -0.67 -0.69 -0.32
(-0.28) (-0.60) (-0.65) (-1.76) (-5.55) (-2.42) (-2.13)
Amihud 0.57 0.30 0.47 0.68 1.92 0.80 0.94 1.37
(2.28) (1.60) (2.57) (3.23) (6.70) (4.15) (3.67)
Turnover -0.73 -0.25 -0.32 -0.48 -0.79 -0.53 -0.70 -3.38
(-2.62) (-1.16) (-1.51) (-1.92) (-2.53) (-2.28) (-2.79)
BIDASK 0.08 -0.03 -0.04 0.27 1.12 0.28 0.41 1.50
(0.34) (-0.15) (-0.22) (1.37) (4.48) (1.58) (1.79)
Volume -0.69 -0.37 -0.49 -0.68 -1.77 -0.81 -0.99 -2.07
(-2.95) (-2.02) (-2.83) (-3.18) (-6.32) (-4.31) (-4.36)

87
ZP 0.67 0.38 0.29 0.54 1.43 0.66 0.76 1.70
(2.88) (2.08) (1.61) (2.68) (5.74) (3.61) (3.70)
CS -0.80 -0.21 -0.14 0.00 1.21 0.05 0.29 2.67
(-2.40) (-0.94) (-0.63) (-0.00) (3.25) (0.22) (0.89)
C 0.01 0.26 0.24 0.61 1.82 0.63 0.76 1.20
(0.05) (1.36) (1.33) (3.34) (6.37) (3.32) (2.79)

87
illiquidity measure, turnover, bid-ask spread, dollar volume, zero return proportion, and

effective trading cost are considerably higher among biased stocks. For instance, low

priced stocks outperform high priced stocks by 2.52% per month among the most biased

stocks, while this return difference is only 0.09% when only the least biased stocks are

considered.

2.8 Extension: Using data from the United Kingdom

One of the main advantages of our bias measure is that it is very simple to construct,

and it can be applied in many settings where data such as trading volume, bid-ask spread,

and daily high and low prices are either unavailable or unreliable. To demonstrate this,

we study the illiquidity effect on cross-section stock returns in the United Kingdom

(UK)33. UK is particularly interesting because Lee (2011) shows that, according to zero

return proportion measure, stocks listed on major UK exchanges are more illiquid (have

more zero-return trading days) than most of the emerging markets. Furthermore, Lee

(2011) also shows that zero return proportion is a negative cross-section return

predicator34. That is, stocks with more zero return trading day exhibit lower average

returns than stocks with less zero return trading day. We investigate whether these

counter-intuitive results can also be observed using our bias measure. Panel A of Table

2.6 reports the summary characteristics of our bias measure along with liquidity proxies

that are commonly used in International liquidity literature: Zero return (ZP), Amihud

33
We obtain data from Datasteam/Worldscope and apply several screening procedures for monthly and
daily returns, as suggested by Ince and Porter (2006) and Lee (2011). We also follow Hou, Karolyi, and
Kho (2011) to construct Size, Book-to-Market equity, Cash flow-to-Price ratio, and Momentum.
34
See Lee (2011) Table 3.
88
 Panel A: Comparison between liquidity proxies
Stdandard 25th 50th 75th
Mean
Deviation percentile percentile percentile
Bias (Basis) -0.36 1.33 -0.83 -0.27 0.11
ZP 0.44 0.28 0.23 0.46 0.59
Amihud 9.85 195.09 0.00 0.04 0.20
BIDASK (%) 6.50 7.49 1.96 4.09 8.26
CS (%) 2.07 4.18 0.42 0.85 2.03
Panel B: Fama-MacBeth Regressions
(1) (2) (3) (4) (5) (6)
Log(Size) -0.01 -0.01 -0.03 0.08 0.07 0.04
(-0.22) (-0.23) (-0.89) (1.33) (1.36) (0.73)
Log(BE/ME) 0.22 0.22 0.22 0.19 0.17 0.22
(4.11) (4.05) (4.12) (2.51) (2.18) (3.95)
CFP+ 0.58 0.59 0.57 0.77 0.85 0.92
(2.63) (2.69) (2.61) (2.10) (2.57) (3.27)
CFP/- dummy -0.40 -0.37 -0.34 -0.51 -0.57 -0.47
(-2.46) (-2.32) (-2.00) (-2.76) (-3.32) (-3.08)
Momentum 1.41 1.46 1.42 1.42 1.45 1.28
(6.64) (6.92) (6.77) (5.53) (5.88) (6.06)
Log(Price) -0.08 -0.09 -0.07 -0.02 -0.02 0.02
(-1.39) (-1.42) (-1.26) (-0.37) (-0.27) (0.23)
ret-1:-1 -1.08 -1.12 -1.10 0.08 0.07 -0.27
(-2.35) (-2.46) (-2.46) (0.15) (0.13) (-0.56)
Bias 9.35
(2.29)
ZP -0.14
(-0.38)
Amihud1 -0.14
(-0.26)
BIDASK2 0.92
(0.90)
CS3 2.09
(1.05)
Table 2.6: Illiquidity of stocks listed on major exchanges in United Kingdom
This table reports the summary statistics of different liquidity proxies and the results of Fama-
MacBeth regressions using stocks listed on major exchange in United Kingdom. Panel A
reports the time-series average of cross-sectional statistics for the bias measure and other
liquidity proxies that are commonly used in the literature. In addition, Panel B reports the time-
series average coefficients and their t-statistics (in parentheses) from monthly Fama-MacBeth
(1973) cross-sectional regressions of individual stock returns on various firm-level
characteristics and liquidity proxies.
1: From January, 1995 to December, 2009
2: From January, 1995 to December, 2009
3: From July, 1987 to December, 2009

89
illiquidity (Amihud), Bid-Ask Spread (BIDASK), and Corwin and Shultz (2011) measure

(CS). Consistent with Lee (2011), we also find that UK stocks on average have a high

proportion of zero return trading days. Specifically, an average UK stock in our sample

has 44% zero return trading days in prior year, while an average US stock has 18% zero

return trading days in prior year. On the other hand, bias measure is on average -0.36

basis points, while that number is approximately 1 basis point in the US.

Panel B of Table 2.6 reports the pricing impact of illiquidity according to different

liquidity proxies. First column confirms the standard results found in the literature that

average returns are negatively related to size, past one month return, and share price, and

positively related to BE/ME, Cash flow-to-Price, and momentum35. In addition to these

standard control variables, Column 2 to 6 also includes different liquidity proxies one at a

time.

Similar to the evidence from the US sections, result from Column 2 confirms that

stocks in UK with larger bias (or more illiquid) tends to have higher average return,

ceteris paribus. The coefficient on bias is 9.35% (t statistic = 2.29). In untabulated results,

we find that the average bias spread in UK is 4.73 basis points between the extreme bias-

sorted decile portfolios. Hence, the coefficient on bias implies a difference in returns

between the extreme deciles of 44 basis points per month.

On the other hand, we use alternative liquidity proxies to try to uncover liquidity

premium in Column 3-6, but we obtain inconsistent results. We find a negative liquidity

premium when using ZP or Amihud as a proxy for liquidity. Specifically, the coefficient

35
See Hou, Karolyi, and Kho (2011) for a comprehensive review for these findings in international setting.
90
on ZP is -0.14 (t statistic = -0.38), while that is -0.14 (t statistic = -0.26) for Amihud.

Although the coefficients are not statistically significant, but the associated negative signs

are inconsistent with the idea that illiquidity is costly and risky to investors. In addition,

the coefficients on BIDASK and CS are positive but statistically insignificant. Overall,

the bias measure uncovers a liquidity premium that is both economically and statistically

significant, while using other liquidity proxies provide inconclusive results.

2.9 Conclusion

In this paper, we propose a parsimonious measure to characterize the severity of the

microstructure bias (e.g., bid-ask bounce) at the individual stock level and assess the

impact of this microstructure induced illiquidity on cross-sectional return predictability.

Our measure, bias, can be directly motivated by Blume and Stambaugh (1983), where

they show that microstructure noises such as “bid-ask bounce”, non-synchronous trading,

orders originating with uninformed traders, and temporary “price pressure” from large

orders can induce upward bias (due to Jensen’s inequality) in average observed stock

returns. Our measure essentially captures the degree of this upward bias at the individual

stock level.

To demonstrate the applicability of our measure, we first apply our bias measure in

the US stock market and find that, consistent with conventional wisdom, firms with the

largest microstructure bias are low priced, small, and volatile. In addition, we find that

our bias measure is highly correlated with commonly used liquidity proxies in the US

stock market such as Amihud, CS, ZP, dollar volume, share turnover, and bid-ask spread

91
used in Amihud and Mendelson (1986) and Brennan, Chordia, and Subrahmanyam

(1998), and C-measure by Hasbrouck (2009). Lastly, we construct the market-wide

average bias measure, and by examining the time-series of this measure, we see that our

bias measure displays considerable variation over time. For instance, the recessions of

1974 to 1975 and 1990 to 1991, the tech bubble of the late 1990s, and the financial crisis

of 2007-2009 are clearly visible. These results suggest that our bias measure indeed

captures liquidity.

Furthermore, stocks with the largest bias (Most illiquid stocks) command a return

premium as large as 9.61% per year, even after controlling for the premiums associated

with size, book-to-marke, momentum, and traditional liquidity price impact and cost

measures. The bias premium can reach as high as 16.21% per year when stocks are

weighted equally. Our finding is consistent with the idea that illiquidity is both costly and

risky to investors. These results are confirmed for a number of specifications, return

adjustments, and subsamples. In addition to the promising unconditional return

predictability, we also find that the bias premium is much larger among small, volatile,

and value stocks and is predominant among worst past performing stocks and long term

losers. These findings are consistent with the consensus that illiquidity is more of a

problem among small, value, volatile, and price momentum losers. In addition, using UK

data, our measure also documents a significant positive cross-section relation between

average stock returns and illiquidity, while the other conventional liquidity does not.

92
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