Forecast Dispersion and the Cross Section of Expected Returns
- Author(s): TIMOTHY C. JOHNSON
- Published: Nov 27, 2005
- Pages: 1957-1978
- DOI: 10.1111/j.1540-6261.2004.00688.x
Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' earnings forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when asset values are unobservable. The relationship then follows from a general options‐pricing result: For a levered firm, expected returns should always decrease with the level of idiosyncratic asset risk. This story is formalized with a straightforward model. Reasonable parameter values produce large effects, and the theory's main empirical prediction is supported in cross‐sectional tests.