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Forecast Dispersion and the Cross Section of Expected Returns



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    • Timothy C. Johnson is at the Institute of Finance and Accounting, London Business School. I am grateful to Christopher Malloy and Andrew Jackson for thoughtful comments and suggestions. I am also indebted to Richard C. Green (the editor) and to the referee for valuable expositional advice. IBES International Inc. provided earnings forecast data, available through the Institutional Brokers Estimate System.


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.