Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility

Stanislav Bozhkov; Habin Lee; Uthayasankar Sivarajah; Stella Despoudi; Monomita Nandy

doi:10.1007/s10479-018-2846-7

Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility

Stanislav Bozhkov, Habin Lee, Uthayasankar Sivarajah, Stella Despoudi, Monomita Nandy

Aston Business School

Research output: Contribution to journal › Article › peer-review

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

Original language	English
Pages (from-to)	419–452
Journal	Annals of Operations Research
Volume	294
Early online date	6 Apr 2018
DOIs	https://doi.org/10.1007/s10479-018-2846-7
Publication status	Published - Nov 2020

Bibliographical note

© The Author(s) 2018. This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made.

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Idiosyncratic risk and the cross-section of stock returns
© The Author(s) 2018. This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made.
Final published version, 602 KBLicence: CC BY 3.0

Cite this

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title = "Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility",

abstract = "A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncraticrisk 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 {\textquoteleft}knowledge{\textquoteright} of the security among market participants. In particular, the premium for Nasdaq-traded stocks is higher than that for NYSE and Amex stocks",

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N2 - A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncraticrisk 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

AB - A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncraticrisk 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

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Idiosyncratic risk and the cross-section of stock returns: the role of mean-reverting idiosyncratic volatility

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