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Risk appetite, idiosyncratic volatility and expected returns

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  • Qadan, Mahmoud

Abstract

This paper examines the variations in idiosyncratic volatility in stock returns over time, and evaluates the role of investor sentiment in explaining these variations. This study uses Fama and French's (2015) 5-factor model to calculate the idiosyncratic volatility with data from the Center for Research in Security Prices (CRSP) for 1980–2016, and analyzes the effects of investors' risk appetite reflected by market-based, press-based, and survey-based proxies for investor sentiment on the relationship between expected returns and idiosyncratic volatility. The findings demonstrate that risk appetite plays a significant role in explaining and predicting variations in this relationship over time. Specifically, when risk appetite increases, there is a shift from safer to more speculative stocks that is translated into positive effect on the relationship between expected returns and idiosyncratic volatility. In contrast, a lack of appetite for risk has the opposite effect. The results are robust using different subsamples and econometric procedures.

Suggested Citation

  • Qadan, Mahmoud, 2019. "Risk appetite, idiosyncratic volatility and expected returns," International Review of Financial Analysis, Elsevier, vol. 65(C).
    • Handle: RePEc:eee:finana:v:65:y:2019:i:c:s1057521919301760
    DOI: 10.1016/j.irfa.2019.101372
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    Cited by:

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    More about this item

    Keywords

    Cross-section of stock returns; Idiosyncratic volatility; Predictability; Investor sentiment;
    All these keywords.

    JEL classification:

    • F39 - International Economics - - International Finance - - - Other
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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