Will firm quality determine the relationship between stock return and idiosyncratic volatility? A new investigation of idiosyncratic volatility

Idiosyncratic volatility generates a lot of interest in literature, as there are conflicting evidences regarding the relationship between stocks’ idiosyncratic volatility and future returns. In this paper, we re-investigate this relationship. We argue that the impact of idiosyncratic volatility on stock return is contextual, i.e., depending on the stocks’ attributes. We focus on stocks’ quality measures. We hypothesize that for companies with high quality measures, the idiosyncratic volatility would have a positive impact on stock return, as it is more likely to be idiosyncratic volatilities on the good side, while on the other hand, for companies with bad qualities, higher idiosyncratic volatility might lead to negative return, as these companies are facing larger default probabilities due to their higher idiosyncratic volatilities. Our empirical results show that within our expectations, for stocks with higher quality measures there is a positive and significant relationship between stocks’ future return and their idiosyncratic volatility, while the story for stocks with lower quality measures is mixed. Our research will contribute to the idiosyncratic volatility literature by providing a thorough and conditional analysis about its impact on stock returns. It will also provide insights for the investors who wish to better understand the impact of idiosyncratic volatility on future stock return and, thus, are able to make better investment decisions.