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Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

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  • Robert F. Stambaugh
  • Jianfeng Yu
  • Yu Yuan
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Abstract

Short selling, as compared to purchasing, faces greater risks and other potential impediments. This arbitrage asymmetry explains the negative relation between idiosyncratic volatility (IVOL) and average return. The IVOL effect is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. The negative effect is stronger, consistent with asymmetry in risks and other impediments inhibiting arbitrageurs in exploiting overpricing. Aggregating across all stocks therefore yields a negative relation, explaining the IVOL puzzle. Further supporting our explanation is a negative relation over time between the IVOL effect and investor sentiment, especially among overpriced stocks.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18560.

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Date of creation: Nov 2012
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Handle: RePEc:nbr:nberwo:18560

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