Return Dispersion and the Cross-Section of Stock Returns

81 Pages Posted: 29 Jun 2018 Last revised: 14 Jul 2020

See all articles by Wei Liu

Wei Liu

Texas A&M University - Department of Finance

James W. Kolari

Texas A&M University - Department of Finance

Jianhua Huang

Texas A&M University - Department of Statistics

Date Written: March 2, 2020

Abstract

Stock returns can have positive and negative sensitivity to the cross-sectional standard deviation of returns or return dispersion (RD). To capture asymmetric RD effects, we propose a new asset pricing model dubbed the ZCAPM that takes into account beta risk associated with the market factor and zeta risk related to positive and negative RD factor movements. To deal with the unobservable sign of the RD sensitivity, the expectation-maximization (EM) algorithm is used to fit the ZCAPM to data. Out-of-sample cross-sectional tests of U.S. stock portfolios yield highly significant estimates for the market price of zeta risk with t-statistics normally in the range of 3 to 6. Our results for zeta risk dominate loadings of popular multifactors, which are less significant across different test assets and sample periods. Strikingly, cross-sectional regression R-squared values for the ZCAPM as high as 94 percent are obtained for size and book-to-market sorted portfolios. Moreover, estimates of the market premium for zeta risk are economically substantial. We conclude that the ZCAPM represents a major innovation in asset pricing for academic research and investment practice.

Keywords: Asset pricing, Cross-sectional stock returns, Expectation-maximization (EM) algorithm, Return dispersion

JEL Classification: G12, C20

Suggested Citation

Liu, Wei and Kolari, James W. and Huang, Jianhua, Return Dispersion and the Cross-Section of Stock Returns (March 2, 2020). Mays Business School Research Paper No. 3200095, Available at SSRN: https://ssrn.com/abstract=3200095 or http://dx.doi.org/10.2139/ssrn.3200095

Wei Liu

Texas A&M University - Department of Finance ( email )

430 Wehner
College Station, TX 77843-4218
United States

James W. Kolari (Contact Author)

Texas A&M University - Department of Finance ( email )

MS-4218
Department of Finance
College Station, TX TX 77843-4218
United States
979-845-4803 (Phone)
979-845-3884 (Fax)

Jianhua Huang

Texas A&M University - Department of Statistics ( email )

155 Ireland Street
447 Blocker
College Station, TX 77843
United States

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