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

Kent Daniel, David Hirshleifer and Avanidhar Subrahmanyam

No 7615, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: G1 (search for similar items in EconPapers)
Date: 2000-03
New Economics Papers: this item is included in nep-fin and nep-fmk
Note: AP
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Published as Overconfidence, Arbitrage, and Equilibrium Asset Pricing. Kent Daniel, David Hirshleifer and Avanidhar Subrahmanyam, Journal of Finance, 56(3), June, (2001):921-965.

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