Abstract
Recent evidence (Stambaugh, Yu, and Yuan, 2015) indicates that the most promising explanation for the negative price of idiosyncratic volatility is from its function as a limit arbitrage. Our evidence incorporating firm specific news is inconsistent with the limited arbitrage explanation. Since mispricing is most likely to occur during news announcements, the pricing of news volatility (volatility contemporaneous to news announcements) should be stronger than that of non-news volatility (volatility without an identified news announcement). We find the opposite. Non-news volatility has robust negative price and lacks some of the key features expected from the limited arbitrage explanation. We conclude that the pricing of idiosyncratic volatility is beyond its function as a limit of arbitrage. In addition, we consider evidence at odds with explanations based on difference of investor opinion and investor sentiment. Hence the pricing of idiosyncratic volatility is a deeper puzzle.
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