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Idiosyncratic Risk, Long-Term Reversal, and Momentum

Published online by Cambridge University Press:  08 June 2010

R. David McLean
R. David McLean*
Affiliation:
University of Alberta, School of Business, 4-20K Business Bldg., Edmonton, Alberta T6G 2R6, Canada. [email protected]
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Abstract

This paper tests whether the persistence of the momentum and reversal effects is the result of idiosyncratic risk limiting arbitrage. Idiosyncratic risk deters arbitrage, regardless of the arbitrageur’s diversification. Reversal is prevalent only in high idiosyncratic risk stocks, suggesting that idiosyncratic risk limits arbitrage in reversal mispricing. This finding is robust to controls for transaction costs, informed trading, and systematic relations between idiosyncratic risk and subsequent returns. Momentum is not related to idiosyncratic risk. Momentum generates a smaller aggregate return than reversal, so the findings along with those in related studies suggest that transaction costs are sufficient to prevent arbitrageurs from eliminating momentum mispricing.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 45 , Issue 4 , August 2010 , pp. 883 - 906
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2010

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