Idiosyncratic Volatility, Growth Options, and the Cross-Section of Returns

Abstract

The paper shows that the value effect and the idiosyncratic volatility discount (Ang et al., 2006) arise because growth firms and high idiosyncratic volatility firms beat the CAPM during the periods of increasing aggregate volatility, which makes their risk low. Growth options become less sensitive to the underlying asset value as idiosyncratic volatility goes up together with aggregate volatility. Hence, growth options' betas decrease more and their value decreases less in volatile times, which are typically recessions. All else equal, growth options' value also increases with volatility. The impact of both effects on the firm's value is naturally stronger for growth firms and high idiosyncratic volatility firms. The two-factor ICAPM with the market factor and the aggregate volatility risk factor completely explains the value effect and the idiosyncratic discount. The two-factor ICAPM also explains why those puzzles are stronger for the firms with high short sale constraints.