Working Papers

A Separation Analysis of the Idiosyncratic Volatility-Return Relation (with George Jiang, Gady Jacoby and Lei Lu).

Abstract: We employ a two-step estimation method to separate the upside and downside idiosyncratic volatility and examine its relation with future stock returns. We find that idiosyncratic volatility is negatively related to stock returns when the market is up and when it is down. The upside idiosyncratic volatility is not related to stock returns. Our results also suggest that the relation between downside idiosyncratic volatility and future stock returns is negative and significant. It is the downside idiosyncratic volatility that drives the inverse relation between total idiosyncratic volatility and stock returns. The results are consistent with the literature that investor overreact to bad news and underreact to good news.

Implied Asset Volatility and Stock Misvaluation: A Mertonian Perspective (with Xiankui Hu and Nanying Lin).

Abstract: The Merton’s (1974) credit risk model considers equity a call option, where the underlying asset is the firm’s assets. This study proposes a novel application of Merton’s model, focusing on implied asset volatility as a model’s outcome. The implied asset volatility represents the volatility of the firm’s assets to justify the equity price, given a capital structure. Among individual equities, a smirk of the implied asset volatility on equity moneyness exists, that high volatility is needed for deep in-the-money equities, and the steepness of the smirk positively covaries with investors’ sentiment. Following the literature, this study considers that implied asset volatility unveils the expensiveness of equity price. This study proposes a novel misvaluation measure as a ratio that compares Merton’s implied asset volatility to a naïve asset volatility. This ratio is high if excess volatility is needed to explain the equity price, indicating the equity price is relatively high. It shows that our misvaluation correlates to existing mispricing measures in the literature, and stocks with tight short-sale constraints are likely overvalued. Further empirical analyses show that common cross-sectional anomalies are more prominent in highly overvalued stocks than undervalued ones, indicating that common anomalies are likely driven by misvaluation effects.

Short-selling Profitability, Stock Lending Fees, and Asset Pricing Anomalies (with Zhi Da, Nanying Lin and Lei Lu).

Abstract: We measure a stock’s short-selling profitability (SSP) as its price sensitivity to short-selling activities over recent periods. Our results show that short-selling strongly and negatively predicts future returns among high-SSP stocks. Furthermore, we identify SSP as a novel determinant of stock lending fees in the cross-section. While the profitability of anomalies decreases when accounting for short-selling fees, they remain exploitable among high-SSP stocks. These findings support a competitive, yet non-monopolistic, stock lending market, where lenders allow short sellers to retain a portion of the profits generated from arbitraging anomalies. This suggests that short-selling constraints are not the sole driver of anomalies, at least among high-SSP stocks.