Idiosyncratic volatility, the VIX and stock returns

Abstract

The interplay between stock returns and idiosyncratic volatility (IVOL) has been subject to extensive empirical investigation, yielding mixed findings. Earlier empirical investigation found either a positive relationship between expected returns and idiosyncratic volatility or none at all, the latter consistent with classical asset pricing theory. Further recent empirical research suggested a negative relationship between the variables. In this study, we use data about US firms from 1990 to 2016 and show that the aggregate market volatility risk, captured by the VIX, plays a role in the relationship between IVOL and stock returns. Specifically, an increase (decline) in the VIX tends to be followed by a negative (positive) relationship between idiosyncratic volatility and future returns, even after taking into account other risk factors. We maintain that an increase in the VIX, also called the investors’ fear gauge, may reflect an increase in investors’ risk aversion, prompting them to balance their portfolios by increasing the diversity of their investments.