Forecast Dispersion and the Cross Section of Expected Returns

Recent work by <link rid="b7">Diether, Malloy, and Scherbina (2002)</link> 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. Copyright 2004 by The American Finance Association.