Residual variance and asset pricing in the art market

Abstract

In this paper, we compute residual variance of art prices to examine asset pricing in contemporary art market. Our empirical work shows a few interesting results. First, we discover that the residual variance is significantly and positively related to the average price level achieved by an artist. Second, the residual variance has additional explanatory power in terms of how often the artist’s works are cited and exhibited, even after we control for artist fixed (reputation) effects. Third, collectors tend to value more those artworks with higher residual variance. Artworks by those artists with high residual variance tend to outperform the market within and out of sample. One possible explanation of our results is that residual variance could be a proxy for creative risk taking by contemporary artists. The most creative artists dare to take more risks, which results in higher residual price volatility of their artworks.