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Is idiosyncratic volatility related to returns? Evidence from a subset of firms with quality idiosyncratic volatility estimates

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  • Bergbrant, Mikael
  • Kassa, Haimanot

Abstract

The empirical relation between idiosyncratic volatility (IVOL) and returns is mixed. Ang et al. (2006, 2009) report a negative relation using lagged realized IVOL, but Fu (2009) shows that this measure is a poor proxy for expectations and proposes using forecasts from EGARCH models which results in a positive relation. However, recent studies show that this positive relation disappears when using out-of-sample EGARCH models to generate the forecasts. We show that expected IVOL proxies used in the prior literature are noisy and propose using combinations of out-of-sample IVOL forecasts generated by different EGARCH models that pass basic diagnostic tests. For the sample for which these high-quality proxies can be created, we find a significant positive relation with returns. The magnitude is both statistically and economically meaningful as firms with expected idiosyncratic volatility of one standard deviation above the mean have expected returns that are approximately 3.4% to 4.1% higher per year.

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  • Bergbrant, Mikael & Kassa, Haimanot, 2021. "Is idiosyncratic volatility related to returns? Evidence from a subset of firms with quality idiosyncratic volatility estimates," Journal of Banking & Finance, Elsevier, vol. 127(C).
    • Handle: RePEc:eee:jbfina:v:127:y:2021:i:c:s0378426621000844
    DOI: 10.1016/j.jbankfin.2021.106126
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    1. Brockman, Paul & Guo, Tao & Vivero, Maria Gabriela & Yu, Wayne, 2022. "Is idiosyncratic risk priced? The international evidence," Journal of Empirical Finance, Elsevier, vol. 66(C), pages 121-136.

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    More about this item

    Keywords

    Idiosyncratic volatility; Priced risk factors; GARCH; EGARCH; Conditional expected volatility; Conditional error variance;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • 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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