Pricing Implications of Noise

Christian L Goulding, Shrihari Santosh and Xingtan Zhang

The Review of Financial Studies, 2023, vol. 36, issue 6, 2468-2508

Abstract: We study the interaction between noisy demand and skewed asset payoffs. In our model, price as a function of quantities is convex in a neighborhood around zero if and only if skewness is positive. The combination of convexity and noise produces the idiosyncratic skewness effect, a documented negative relationship between an asset’s idiosyncratic skewness and its expected return. We further offer an explanation for the idiosyncratic volatility puzzle. Finally, our theory predicts that higher idiosyncratic skewness strengthens the idiosyncratic volatility effect (and vice versa). We find support for this prediction in the cross-section of stock returns.

JEL-codes: D53 D82 G12 (search for similar items in EconPapers)
Date: 2023
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