Distribution Effect and Idiosyncratic Volatility Discount

Abstract

Based on information signaling theory, this paper empirically shows that distribution effect matters for idiosyncratic volatility discount. Idiosyncratic volatility discount arises primarily among stocks with non-cash distributions. Such stocks show a significant idiosyncratic volatility discount, measured by the return difference between high and low idiosyncratic volatility portfolios. For stocks with cash distributions, this discount is statistically insignificant. We attribute these effects to the fact that the information content of cash distributions reduces the uncertainty of future capital gains, which in turn drives out the idiosyncratic volatility discount. We test several explanations of idiosyncratic volatility discount under the framework of distribution effect and find evidence contrary to those explanations. In addition, our empirical results suggest that extreme values may obscure some of the extant explanations on idiosyncratic volatility discount.