Forecast dispersion and the cross section of expected returns

Johnson, T (2003) Forecast dispersion and the cross section of expected returns. Working Paper. London Business School IFA Working Paper.

Abstract

Recent work by Diether, Malloy, and Scherbina (2002) has established a negative relationship between stock returns and the dispersion of analysts' forecasts. I offer a simple explanation for this phenomenon based on the interpretation of dispersion as a proxy for unpriced information risk arising when underlying asset values are unobservable. The relationship then follows from a general optionspricing 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 crosssectional tests.