| dc.description.abstract | Merton (1987) posits that in the presence of incomplete information, investors hold less diversified portfolios and thus require higher excess returns, leading to a positive correlation between idiosyncratic risk and cross-sectional returns. Building on Merton’s original model, this study distinguishes between institutional investors and retail investors, further categorizing institutional investors into short-term and long-term groups. By constructing the shadow cost of incomplete information (λ), which consists of relative market size, shareholder base, and idiosyncratic risk, this study finds that the shadow cost of retail investors (λ^R) and short-term institutional investors (λ^STI) is significantly positively correlated with cross-sectional returns. This indicates that these investors bear idiosyncratic risk and receive a recognition premium, as predicted by Merton’s investor recognition hypothesis.
Further, this study analyze the impact of short-term institutional investors on recognition premiums. It reveals a positive contribution to the risk premium for overall institutional investors, but a negative impact on retail investors, aligning them more closely with the role of rational arbitrageurs in the market. Comparing these findings with Miller’s (1977) divergence of opinion, the study discovers that in the presence of short-selling constraints and divergent opinions, the premiums obtained by retail investors stem from idiosyncratic risk, supporting Merton’s (1987) model. | en_US |