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Expected Volatility, Unexpected Volatility, And The Cross‐Section Of Stock Returns

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  • Choong Tze Chua
  • Jeremy Goh
  • Zhe Zhang

Abstract

The existing literature finds conflicting results on the cross‐sectional relation between expected returns and idiosyncratic volatility. We contend that at the firm level, the sample correlation between unexpected returns and expected idiosyncratic volatility can cloud the true relation between the expected return and expected idiosyncratic volatility. We show strong evidence that unexpected idiosyncratic volatility is positively related to unexpected returns. Using unexpected idiosyncratic volatility to control for unexpected returns, we find expected idiosyncratic volatility to be significantly and positively related to expected returns. This result holds after controlling for various firm characteristics, and it is robust across different sample periods.

Suggested Citation

  • Choong Tze Chua & Jeremy Goh & Zhe Zhang, 2010. "Expected Volatility, Unexpected Volatility, And The Cross‐Section Of Stock Returns," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 33(2), pages 103-123, June.
    • Handle: RePEc:bla:jfnres:v:33:y:2010:i:2:p:103-123
    DOI: 10.1111/j.1475-6803.2010.01264.x
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    10. Qadan, Mahmoud, 2019. "Risk appetite, idiosyncratic volatility and expected returns," International Review of Financial Analysis, Elsevier, vol. 65(C).
    11. Nartea, Gilbert V. & Wu, Ji & Liu, Zhentao, 2013. "Does idiosyncratic volatility matter in emerging markets? Evidence from China," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 137-160.
    12. Guo, Hui & Qiu, Buhui, 2014. "Options-implied variance and future stock returns," Journal of Banking & Finance, Elsevier, vol. 44(C), pages 93-113.
    13. Son, Nguyen Truong & Nguyen, Nhat Minh, 2019. "Prospect theory value and idiosyncratic volatility: Evidence from the Korean stock market," Journal of Behavioral and Experimental Finance, Elsevier, vol. 21(C), pages 113-122.
    14. Peterson, David R. & Smedema, Adam R., 2011. "The return impact of realized and expected idiosyncratic volatility," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2547-2558, October.
    15. Chris Godfrey & Chris Brooks, 2015. "The Negative Credit Risk Premium Puzzle: A Limits to Arbitrage Story," ICMA Centre Discussion Papers in Finance icma-dp2015-07, Henley Business School, University of Reading.
    16. Mu-Shun Wang, 2013. "Idiosyncratic Volatility and the Expected Stock Returns for Exploring the Relationship with Panel Threshold Regression," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 20(2), pages 113-129, May.
    17. Chuxuan Xiao & Winifred Huang & David P. Newton, 2024. "Predicting expected idiosyncratic volatility: Empirical evidence from ARFIMA, HAR, and EGARCH models," Review of Quantitative Finance and Accounting, Springer, vol. 63(3), pages 979-1006, October.
    18. Kevin Aretz & Ming-Tsung Lin & Ser-Huang Poon, 2023. "Moneyness, Underlying Asset Volatility, and the Cross-Section of Option Returns," Review of Finance, European Finance Association, vol. 27(1), pages 289-323.
    19. Jain, Ajeet & Strobl, Sascha, 2017. "The effect of volatility persistence on excess returns," Review of Financial Economics, Elsevier, vol. 32(C), pages 58-63.
    20. Hassen Raîs, 2016. "Idiosyncratic Risk and the Cross-Section of European Insurance Equity Returns," Post-Print hal-01764088, HAL.
    21. Qadan, Mahmoud & Kliger, Doron & Chen, Nir, 2019. "Idiosyncratic volatility, the VIX and stock returns," The North American Journal of Economics and Finance, Elsevier, vol. 47(C), pages 431-441.
    22. He, Zhongzhi & Xue, Wenjun, 2022. "Idiosyncratic volatility puzzle exists at the country level," The North American Journal of Economics and Finance, Elsevier, vol. 62(C).
    23. Aboulamer, Anas & Kryzanowski, Lawrence, 2016. "Are idiosyncratic volatility and MAX priced in the Canadian market?," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 20-36.
    24. Shi, Yanlin & Liu, Wai-Man & Ho, Kin-Yip, 2016. "Public news arrival and the idiosyncratic volatility puzzle," Journal of Empirical Finance, Elsevier, vol. 37(C), pages 159-172.

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