How financial crises affect the relationship between idiosyncratic volatility and stock returns

Abstract

The current literature is inconclusive as to whether idiosyncratic risk influences future stock returns. While earlier studies are based on historical realized volatility to estimate expected idiosyncratic volatility, Diavatopoulos, Doran and Peterson (2008) find that implied idiosyncratic volatility from option prices has the strongest relationship with future idiosyncratic volatility. In this study, implied idiosyncratic volatility on firms with exchange-traded options is used to examine the relationship between idiosyncratic volatility and stock returns. As the empirical results show that this relationship is affected by the change of the sample period, there is no linear relationship between idiosyncratic volatility and stock returns. In addition, during the period of financial crisis, a strong negative relationship is found between implied idiosyncratic volatility and future returns. This result demonstrates that the volatility caused by the crisis has a significant effect on stock returns.