Covariance Risk, Mispricing, and the Cross Section of Security Returns

47 Pages Posted: 16 May 2000 Last revised: 24 Apr 2022

See all articles by Kent D. Daniel

Kent D. Daniel

Columbia University - Columbia Business School, Finance; National Bureau of Economic Research (NBER)

David A. Hirshleifer

Marshall School of Business, USC; National Bureau of Economic Research (NBER)

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area; Financial Research Network (FIRN)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2000

Abstract

This paper offers a multisecurity model in which prices reflect both covariance risk and misperceptions of firms' prospects, and in which arbitrageurs trade to profit from mispricing. We derive a pricing relationship in which expected returns are linearly related to both risk and mispricing variables. The model thereby implies a multivariate relation between expected return, beta, and variables that proxy for mispricing of idiosyncratic components of value tends to be arbitraged away but systematic mispricing is not. The theory is consistent with several empirical findings regarding the cross-section of equity returns, including: the observed ability of fundamental/price ratios to forecast aggregate and cross-sectional returns, and of market value but not non-market size measures to forecast returns cross-sectionally; and the ability in some studies of fundamental/price ratios and market value to dominate traditional measures of security risk. The model also offers several untested empirical implications for the cross-section of expected returns and for the relation of volume to subsequent volatility.

Suggested Citation

Daniel, Kent D. and Hirshleifer, David A. and Subrahmanyam, Avanidhar, Covariance Risk, Mispricing, and the Cross Section of Security Returns (March 2000). NBER Working Paper No. w7615, Available at SSRN: https://ssrn.com/abstract=228092

Kent D. Daniel (Contact Author)

Columbia University - Columbia Business School, Finance ( email )

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

David A. Hirshleifer

Marshall School of Business, USC ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

HOME PAGE: http://https://sites.uci.edu/dhirshle/

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Avanidhar Subrahmanyam

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-5355 (Phone)
310-206-5455 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
106
Abstract Views
2,920
Rank
41,869
PlumX Metrics