Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility
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Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility Stanislav Bozhkov1 · Habin Lee2 · Uthayasankar Sivarajah3 Stella Despoudi4 · Monomita Nandy1
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© The Author(s) 2018
Abstract A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncratic risk is not priced by investors because in the absence of frictions it can be fully diversified away. In the presence of constraints on diversification, refinements of the CAPM conclude that the part of idiosyncratic risk that is not diversified should be priced. Recent empirical studies yielded mixed evidence with some studies finding positive correlation between idiosyncratic risk and stock returns, while other studies reported none or even negative correlation. We examine whether idiosyncratic risk is priced by the stock market and what are the probable causes for the mixed evidence produced by other studies, using monthly data for the US market covering the period from 1980 until 2013. We find that one-period volatility forecasts are not significantly correlated with stock returns. The mean-reverting unconditional volatility, however, is a robust predictor of returns. Consistent with economic theory, the size of the premium depends on the degree of ‘knowledge’ of the security among market participants. In particular, the premium for Nasdaq-traded stocks is higher than that for NYSE and Amex stocks. We also find stronger correlation between idiosyncratic risk and
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Habin Lee [email protected] Stanislav Bozhkov [email protected] Uthayasankar Sivarajah [email protected] Stella Despoudi [email protected] Monomita Nandy [email protected]
1
Brunel University London, Uxbridge, UK
2
Brunel Business School, Brunel University London, Kingston Lane, Uxbridge UB8 3PH, UK
3
University of Bradford, Faculty of Management and Law Emm Lane, Bradford, West Yorkshire BD9 4JL, UK
4
Coventry University, Coventry, UK
123
Ann Oper Res
returns during recessions, which may suggest interaction of risk premium with decreased risk tolerance or other investment considerations like flight to safety or liquidity requirements. We identify the difference between the correlations of the idiosyncratic volatility estimators used by other studies and the true risk metric the mean-reverting volatility as the likely cause for the mixed evidence produced by other studies. Our results are robust with respect to liquidity, momentum, return reversals, unadjusted price, liquidity, credit quality, omitted factors, and hold at daily frequency. Keywords Idiosyncratic risk · Mean-reverting volatility · Cross section stock returns · Mincer–Zarnowitz regressions
1 Introduction There have been long debates whether idiosyncratic risk is a significant factor in explaining the cross-section of stock returns, and if so, what the direction of that influence is. The capital asset pricing model (CAPM) developed by Sharpe (1964) and Lintner (1965) proposes that in complete, frictionless markets the only factor
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