Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility Around the World

Abstract

This paper examines data from 45 world markets and shows that the previously documented relation between mean returns and idiosyncratic volatility arises because of biases in volatility estimates that we can attribute to the bid-ask bounce in trade prices. We show that no significant relation exists between mean returns and idiosyncratic volatility estimated from quote-midpoint returns. Further, there is no significant relation between mean returns and the portion of transaction-price based idiosyncratic volatility that is orthogonal to bid-ask spreads. The pricing of idiosyncratic volatility is due to the negative pricing of the bid-ask spread.