Relationship between Extreme Idiosyncratic Returns and Expected Returns in the Korean Stock Market

Abstract

This study estimates IMAX and IMIN to measure lottery and hazard stocks, and investigates how investors’ reactions to these extreme returns affect the cross-section of stock returns. We show that IMAX is negatively related to future returns and measures lottery stocks. Furthermore, we show that IMIN also has a negative relationship with future returns, contrary to theory, suggesting the existence of the IMIN anomaly in the Korean stock market. IMIN anomaly, which is caused by investors’ under-reaction to hazard stocks, is significant even after controlling various variables explaining the cross-sectional characteristics of stocks, and lasts for at least 24 months. Moreover, we show that the IMIN anomaly exists significantly even after controlling factors related to investors’ under-reaction, such as investor attention, information uncertainty, and limits to arbitrage. However, IMIN anomaly weakens as the stock market demonstrates more efficiency and transparency.