Sentiment-driven volatility and the idiosyncratic volatility puzzle: Evidence from an emerging market

This study examines whether investor sentiment conditions the cross-sectional pricing of idiosyncratic volatility (IVOL) in the Indian equity market. Motivated by behavioural asset pricing theories, we investigate whether the well-documented instability in the IVOL–return relation reflects underlying market sentiment dynamics rather than a stable risk premium. Using firm-level data from the National Stock Exchange over the period 2001–2024, we construct a unified Investor Sentiment Index (ISI) based on market-wide trading, issuance, and liquidity proxies, and employ both portfolio sorts and Fama–MacBeth cross-sectional regressions to evaluate the conditional pricing of IVOL. The baseline results indicate that IVOL is not a robustly priced factor in an unconditional setting, with weak and statistically insignificant return differentials across volatility-sorted portfolios. However, the relationship becomes state-dependent when conditioned on investor sentiment. Specifically, the pricing of IVOL varies across sentiment regimes, with evidence suggesting that market-wide optimism influences the cross-sectional return patterns associated with firm-specific risk. At the same time, we find that investor sentiment does not significantly explain the variation in idiosyncratic volatility itself, which is primarily driven by firm-level characteristics, liquidity conditions, and extreme return realizations. These findings highlight a clear distinction between risk generation and risk pricing in an emerging market context. While IVOL reflects firm-specific dynamics, its pricing is contingent on prevailing behavioural conditions, consistent with theories of limits to arbitrage and sentiment-driven mispricing. The study contributes to the literature by providing comprehensive evidence from India that the economic relevance of idiosyncratic volatility lies not in unconditional risk pricing, but in its interaction with investor sentiment.