On the Relation between EGARCH Idiosyncratic Volatility and Expected Stock Returns

Abstract

AbstractA spurious positive relation between exponential generalized autoregressive conditional heteroskedasticity (EGARCH) estimates of expected monthtidiosyncratic volatility and monthtstock returns arises when the monthtreturn is included in estimation of model parameters. We illustrate via simulations that this look-ahead bias is problematic for empirically observed degrees of stock return skewness and typical monthly return time series lengths. Moreover, the empirical idiosyncratic risk-return relation becomes negligible when expected monthtidiosyncratic volatility is estimated using returns only up to montht− 1.