Information uncertainties and asset pricing puzzles: risk or mispricing?

Abstract

Purpose

Prior research has documented the role of information uncertainty in the cross-sectional variation in stock returns. Miller (1977) hypothesizes that if information uncertainty is caused by differences of opinion, prices will reflect only the positive beliefs due to short-sale constraints. These anomalous stock price behaviors may result from mispricing. In contrast, Merton (1974) asserts that default risk is a function of the uncertainty in the asset value process. Information uncertainty may be subsumed by credit or default risk. The paper aims to discuss these issues.

Design/methodology/approach

The authors employ various sorting techniques and Fama-MacBeth Regressions to test the hypotheses.

Findings

The authors provide empirical evidence consistent with Merton’s (1974) default risk hypothesis and inconsistent with Miller’s (1977) mispricing hypothesis.

Research limitations/implications

Risk aversion and not misplacing is the primary factor driving information-related anomalies in equities markets.

Practical implications

It would be quite difficult to find arbitrage opportunities in equities markets because there appears to be little, if any, mis-pricing due to information uncertainties.

Originality/value

This study provides important information about the primary underlying information-related source of certain empirical anomalies in the cross-section of stock returns.

Citation

Li, K., Uddin, M.R. and Diltz, J.D. (2015), "Information uncertainties and asset pricing puzzles: risk or mispricing?", Managerial Finance, Vol. 41 No. 12, pp. 1280-1297. https://doi.org/10.1108/MF-10-2014-0267