The conditional relation between dispersion and return

• Published date: 01 September 2013
• Author: Shrikant P. Jategaonkar,Rıza Demirer
• Date: 01 September 2013
• DOI: http://doi.org/10.1016/j.rfe.2013.04.004

The conditional relation between dispersion and return

Rıza Demirer ⁎, Shrikant P. Jategaonkar

Department of Economics & Finance, Southern Illinois University Edwardsville, Edwardsville, IL 62026–1102, United States

abstractarticle info

Article history:

Received 21 June 2012

Received in revised form 28 February 2013

Accepted 17 April 2013

Available online 25 April 2013

JEL Classification:

G11

G12

Keywords:

Return dispersion

Conditional pricing effect

Asymmetric risk

Asset pricing

The main goal of this paper is to examine the conditional pricing effect of return dispersion on the cross section

of returns. We observe a systematic conditional relation between dispersion and return even after controlling

for market, size and book-to-market factors. However, we find that return dispersion risk is asymmetrically

priced with a significantly positive premium observed during periods of large market gains only. The findings

are found to be robust to alternative conditional specifications of market returns, suggesting asymmetric pric-

ing effect of the return dispersion factor. We provide alternative explanations for the systematic risk captured

by the return dispersion factor and discuss implications for portfolio management and corporate decisions.

© 2013 Elsevier Inc. All rights reserved.

1. Introduction

The relation between security returns and the different systematic

risk factors driving them has been extensively studied in the literature.

Starting with the Capital Asset Pricing Model of Sharpe (1964),Lintner

(1965) and Mossin (1966), a great deal of research has been devoted

to understanding how systematic risk factors drive the cross section

of returns.

1

In the asset pricing literature, the Fama-French three-

factor model that incorporates the market, firm size and book-to-

market factors has now become the dominant model.

2

In a recent

study, Jiang (2010) reports that return dispersion, defined as the

cross sectional standard deviation of stock returns around the market

average, carries a significant positive price of risk. Using data on U.S.

stocks, he finds that stocks with greater sensitivities to return disper-

sion yield higher average returns, suggesting a two-factor asset

pricing model that incorporates return dispersion and the market re-

turn. He further notes that the return dispersion factor dominates

the book-to-market factor in the Fama-French model and concludes

that return dispersion captures two dimensions of systematic risk:

the business cycle and economic restructuring.

Several studies in the literature have examined return dispersion

from different angles. These studies suggest that return dispersion is

associated witheconomic uncertainty and the business cycle (Christie

& Huang, 1994; Loungani, Rush, & Tave, 1990), market volatility

(Bekaert and Harvey, 1997, 2000; Stivers, 2003), and idiosyncratic

volatility (Connolly & Stivers, 2006 and Stivers, 2003). Stivers (2003)

and Connolly and Stivers (2006) establish a link between return dis-

persion andaggregate market volatilityand find that return dispersion

provides signals about future aggregate market volatility. Stivers and

Sun (2010) document a link between the time variation in the value

and momentum premiums and the variation in the market's cross-

sectional return dispersion. More recently, Jiang (2010) takes these

studies one step further and incorporates return dispersion into an

asset-pricingmodel and shows that returndispersion is in fact a priced

risk factor.

On the other hand,a growing body of literaturesuggests the notion

of asymmetric risk and asymmetric risk premiums reflected in the

cross-section of stock returns.

3

Examining U.S. stock returns, Ang,

Chen, and Xing (2006) show that asymmetric risk is in fact priced

with a significant downside risk premium observed over the cross

section of returns. More recently, Huang, Liu, Rhee, and Wub (2012)

report a significantly positive extreme downside risk premium even

after controlling for systematic risk factors including market, size and

book-to-market ratio. In another strand of literature, studies including

Christie and Huang (1994) and Duffee (2001) report asymmetries in

observed cross-sectional return dispersions with respect to market

movements. Christie and Huang (1994) find that return dispersion is

Review of Financial Economics 22 (2013) 125–134

⁎Corresponding author. Tel.: +1 618 650 2939; fax: + 1 618 650 3047.

E-mail addresses: rdemire@siue.edu (R. Demirer), sjatega@siue.edu (S.P. Jategaonkar).

1

See,for example, Chen, Roll,and Ross (1986),Haugenand Baker (1996),andBrennan,

Chordia,and Subrahmanyam (1998), amongothers.

2

See Fama and French (1992, 1993, 1996).

3

See for example Longin and Solnik (2001),Silvapulle and Granger (2001),Ang and

Chen (2002), and Campbell, Koedijk, and Kofman (2002) among others.

1058-3300/$ –see front matter © 2013 Elsevier Inc. All rights reserved.

http://dx.doi.org/10.1016/j.rfe.2013.04.004

Contents lists available at SciVerse ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe