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The Dynamic Relation Between Returns and Idiosyncratic Volatility

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  • Xiaoquan Jiang
  • Bong-Soo Lee

Abstract

We claim that regressing excess returns on one-lagged volatility provides only a limited picture of the dynamic effect of idiosyncratic risk, which tends to be persistent over time. By correcting for the serial correlation in idiosyncratic volatility, we find that idiosyncratic volatility has a significant positive effect. This finding seems robust for various firm size portfolios, sample periods, and measures of idiosyncratic risk. Our findings suggest stock markets mis-price idiosyncratic risk. There may be some measurement problems with idiosyncratic risk that could be related to nondiversifiable risk.

Suggested Citation

  • Xiaoquan Jiang & Bong-Soo Lee, 2006. "The Dynamic Relation Between Returns and Idiosyncratic Volatility," Financial Management, Financial Management Association, vol. 35(2), Summer.
  • Handle: RePEc:fma:fmanag:jianglee06
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    Cited by:

    1. Kryzanowski, Lawrence & Mohsni, Sana, 2015. "Earnings forecasts and idiosyncratic volatilities," International Review of Financial Analysis, Elsevier, vol. 41(C), pages 107-123.
    2. Ana Isabel Ramos Domingues & António de Melo da Costa Cerqueira & Elísio Fernando Moreira Brandão, 2016. "Idiosyncratic Volatility and Earnings Quality: Evidence from United Kingdom," FEP Working Papers 579, Universidade do Porto, Faculdade de Economia do Porto.
    3. Andy Fodor & Kevin Krieger & Nathan Mauck & Greg Stevenson, 2013. "Predicting Extreme Returns And Portfolio Management Implications," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 36(4), pages 471-492, December.
    4. Jiang, Xiaoquan & Lee, Bong-Soo, 2014. "The intertemporal risk-return relation: A bivariate model approach," Journal of Financial Markets, Elsevier, vol. 18(C), pages 158-181.
    5. repec:sgm:jbfeuw:v:2:y:2017:i:8:p:27-53 is not listed on IDEAS
    6. Liow, Kim Hiang & Addae-Dapaah, Kwame, 2010. "Idiosyncratic risk, market risk and correlation dynamics in the US real estate investment trusts," Journal of Housing Economics, Elsevier, vol. 19(3), pages 205-218, September.
    7. Guo, Hui & Qiu, Buhui, 2014. "Options-implied variance and future stock returns," Journal of Banking & Finance, Elsevier, vol. 44(C), pages 93-113.
    8. Huang, Biqing & Wald, John & Martell, Rodolfo, 2013. "Financial market liberalization and the pricing of idiosyncratic risk," Emerging Markets Review, Elsevier, vol. 17(C), pages 44-59.
    9. 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.
    10. 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.
    11. Lee, Bong Soo & Mauck, Nathan, 2016. "Dividend initiations, increases and idiosyncratic volatility," Journal of Corporate Finance, Elsevier, vol. 40(C), pages 47-60.
    12. Jen-Sin Lee & Chu-Yun Wei, 2012. "Types of Shares and Idiosyncratic Risk," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 48(S3), pages 68-95, September.
    13. Miffre, Joëlle & Brooks, Chris & Li, Xiafei, 2013. "Idiosyncratic volatility and the pricing of poorly-diversified portfolios," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 78-85.
    14. Xiafei Li & Chris Brooks & Joëlle Miffre, 2009. "The Value Premium and Time-Varying Volatility," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(9-10), pages 1252-1272.
    15. Jen-Sin Lee & Chu-Yun Wei, 2012. "Types of Shares and Idiosyncratic Risk," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 48(S3), pages 68-95, September.
    16. Chris Brooks & Xiafei Li & Joelle Miffre, 2009. "Time Varying Volatility and the Cross-Section of Equity Returns," ICMA Centre Discussion Papers in Finance icma-dp2009-01, Henley Business School, Reading University.
    17. Hassen Raîs, 2016. "Idiosyncratic Risk and the Cross-Section of European Insurance Equity Returns," Post-Print hal-01764088, HAL.
    18. Lee, Bong Soo & Li, Ming-Yuan Leon, 2012. "Diversification and risk-adjusted performance: A quantile regression approach," Journal of Banking & Finance, Elsevier, vol. 36(7), pages 2157-2173.
    19. Knill, April M. & Lee, Bong Soo & Mauck, Nathan, 2012. "Sovereign wealth fund investment and the return-to-risk performance of target firms," Journal of Financial Intermediation, Elsevier, vol. 21(2), pages 315-340.
    20. Xiaoquan Jiang, 2010. "Return dispersion and expected returns," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 24(2), pages 107-135, June.
    21. Vozlyublennaia, Nadia, 2013. "Do firm characteristics matter for the dynamics of idiosyncratic risk?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 27(C), pages 35-46.

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