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An analytical derivation of the relation between idiosyncratic volatility and expected stock return

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  • Don U.A. Galagedera

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Abstract

Modelling stock return generating process as a single factor model, we show analytically that the relation between idiosyncratic volatility measured as variance of the residuals and expected stock return in the cross-section may be represented by a parabola that opens to the left and has horizontal axis. This relation is uncovered for stocks of similar volatility and no abnormal return. The sensitivity of the derived relation when these restrictions are relaxed is discussed. Our findings, to a great extent, help uncover the shape of the non-linear inverse relation between idiosyncratic volatility and expected stock return observed in the cross-section in previous empirical studies.

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File URL: http://www.buseco.monash.edu.au/ebs/pubs/wpapers/2009/wp14-09.pdf
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Bibliographic Info

Paper provided by Monash University, Department of Econometrics and Business Statistics in its series Monash Econometrics and Business Statistics Working Papers with number 14/09.

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Length: 21 pages
Date of creation: Nov 2009
Date of revision:
Handle: RePEc:msh:ebswps:2009-14

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Keywords: Idiosyncratic volatility; expected return; analytical derivation; cross-sectional analysis;

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