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Idiosyncratic Volatility: Evidence from Asia

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  • Michael Drew
  • Madhu Veeraraghavan

Abstract

The traditional Capital Asset Pricing Model states that assets can earn only higher returns if they have a high beta. However, evidence shows that the single risk factor is not quite adequate for describing the cross-section of stock returns. The current consensus is that firm size and book-to-market equity factors are pervasive risk factors besides the overall market factor. Malkiel and Xu (1997 and 2000) further the debate in empirical asset pricing by stating that idiosyncratic volatility is useful in explaining the cross-sectional expected returns. In this paper we provide international evidence on the relationship between expected stock returns, overall market factor, firm size and idiosyncratic volatility. Our findings suggest that size and idiosyncratic volatility premium are real and pervasive. We find that small and high idiosyncratic volatility stocks generate superior returns and hence suggest that such firms carry risk premia. Our findings also suggest that idiosyncratic volatility is more powerful than the CAPM beta and the firm size effect. Our findings challenge the portfolio theory of Markowitz (1952) and the CAPM of Sharpe (1964), which advances the notion that it is rational for a utility maximizing investor to hold a well-diversified portfolio of investments to eliminate idiosyncratic risks.

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File URL: http://external-apps.qut.edu.au/business/documents/discussionPapers/2002/DP%20No%20107.pdf
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Bibliographic Info

Paper provided by School of Economics and Finance, Queensland University of Technology in its series School of Economics and Finance Discussion Papers and Working Papers Series with number 107.

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Date of creation: 20 Mar 2002
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Handle: RePEc:qut:dpaper:107

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Related research

Keywords: Idiosyncratic risk; Portfolio Theory; Capital Asset Pricing Model; Size effect and Beta.;

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References

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  1. Malkiel, Burton & Campbell, John & Lettau, Martin & Xu, Yexiao, 2001. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," Scholarly Articles 3128707, Harvard University Department of Economics.
  2. Daniel, Kent & Titman, Sheridan, 1997. " Evidence on the Characteristics of Cross Sectional Variation in Stock Returns," Journal of Finance, American Finance Association, vol. 52(1), pages 1-33, March.
  3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  4. MacKinlay, A. Craig, 1995. "Multifactor models do not explain deviations from the CAPM," Journal of Financial Economics, Elsevier, vol. 38(1), pages 3-28, May.
  5. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
  6. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  7. Kothari, S P & Shanken, Jay & Sloan, Richard G, 1995. " Another Look at the Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 185-224, March.
  8. Jonathan B. Berk, 2000. "Sorting Out Sorts," Journal of Finance, American Finance Association, vol. 55(1), pages 407-427, 02.
  9. French, Kenneth R. & Schwert, G. William & Stambaugh, Robert F., 1987. "Expected stock returns and volatility," Journal of Financial Economics, Elsevier, vol. 19(1), pages 3-29, September.
  10. Fama, Eugene F & French, Kenneth R, 1995. " Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance, American Finance Association, vol. 50(1), pages 131-55, March.
  11. Fama, Eugene F & French, Kenneth R, 1996. " Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
  12. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
  13. Kent Daniel, 2001. "Explaining the Cross-Section of Stock Returns in Japan: Factors or Characteristics?," Journal of Finance, American Finance Association, vol. 56(2), pages 743-766, 04.
  14. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March.
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Cited by:
  1. Kathleen Goffey & Andrew Worthington, 2002. "Motor Vehicle Usage Patterns in Australia: A Comparative Analysis of Driver, Vehicle & Purpose Characteristics for Household & Freight Travel," School of Economics and Finance Discussion Papers and Working Papers Series 117, School of Economics and Finance, Queensland University of Technology.

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