Abstract
This paper examines the idiosyncratic volatility puzzle and whether investor sentiment influences the relation between idiosyncratic volatility and stock returns in the Chinese stock market. The findings indicate the existence of a negative idiosyncratic volatility effect. In addition, the results show that the relation between idiosyncratic volatility and returns significantly depends on investor sentiment. Thus, investor sentiment plays a very important role in reconciling the relation between idiosyncratic volatility and stock returns in the Chinese stock market. This implies that investor sentiment may be one of the major risk factors that should be considered in the Chinese stock market. In terms of predictive ability of investor sentiment, idiosyncratic volatility and market volatility, the findings indicate that idiosyncratic volatility positively predicts future excess market returns in the Chinese stock market.
Highlights
Recent empirical studies have found a cross-sectional relation between idiosyncratic volatility and expected stock returns
The objectives of this paper are (i) to investigate the idiosyncratic volatility puzzle in China and (ii) to explore whether investor sentiment influences the relation between idiosyncratic volatility and expected stock returns
These findings are an indication that a negative idiosyncratic volatility effect is present in the Chinese stock market underpinning the Ang et al [11] findings of negative idiosyncratic volatility puzzle
Summary
Recent empirical studies have found a cross-sectional relation between idiosyncratic volatility and expected stock returns. Some previous studies suggest either a positive [1,2,3,4,5,6,7,8] or an insignificant [9,10] relationship between idiosyncratic volatility and expected returns. Nartea [7] find evidence of a negative idiosyncratic volatility effect in China supporting the findings of Ang [11]. These relationships exist because investors cannot fully diversify their stock portfolios suggesting that idiosyncratic volatility should be priced. On the other hand, indicates that only systematic risk should be priced because idiosyncratic risk can be diversified away when investors hold a well-diversified portfolio of stocks
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