Return Dispersion and Expected Returns
Financial Markets and Portfolio Management, Vol. 24, No. 2, pp. 107-135, 2010
Posted: 18 Jun 2010
Date Written: December 23, 2009
Abstract
This paper proposes a two-factor asset-pricing model that incorporates market return and return dispersion. Consistent with this model, we find that stocks with higher sensitivities to return dispersion have higher average returns, and that return dispersion carries a significant positive price of risk. In particular, the return dispersion factor dominates the book-to-market factor in explaining cross-sectional expected returns. The return dispersion model outperforms the CAPM, MVM, IVM, and FF-3M when using a set of 5×5 test portfolios constructed from NYSE and AMEX stock returns from August 1963 to December 2005. Return dispersion continues to play an important role in explaining the cross-sectional variation of expected returns, even when market volatility, idiosyncratic volatility, size, book-to-market factors, and a momentum factor are included. This study sheds some light on the ability of return dispersion to explain expected returns beyond the standard asset-pricing factors. Our finding suggests that return dispersion captures two dimensions of systematic risk: the business cycle and fundamental economic restructuring.
Keywords: Return Dispersion, Cross-Sectional Returns, Asset Pricing, Market Volatility, Idiosyncratic Volatility
JEL Classification: G11, G12
Suggested Citation: Suggested Citation