Risk appetite, idiosyncratic volatility and expected returns

Abstract

This paper examines the variations in idiosyncratic volatility in stock returns over time, and evaluates the role of investor sentiment in explaining these variations. This study uses Fama and French's (2015) 5-factor model to calculate the idiosyncratic volatility with data from the Center for Research in Security Prices (CRSP) for 1980–2016, and analyzes the effects of investors' risk appetite reflected by market-based, press-based, and survey-based proxies for investor sentiment on the relationship between expected returns and idiosyncratic volatility. The findings demonstrate that risk appetite plays a significant role in explaining and predicting variations in this relationship over time. Specifically, when risk appetite increases, there is a shift from safer to more speculative stocks that is translated into positive effect on the relationship between expected returns and idiosyncratic volatility. In contrast, a lack of appetite for risk has the opposite effect. The results are robust using different subsamples and econometric procedures.