The cross-section of expected stock returns and components of idiosyncratic volatility

Abstract

PurposeThe purpose of this paper is to contribute to the existing stock return predictability and idiosyncratic risk literature by examining the relationship between stock returns and components derived from the decomposition of stock returns variance at the portfolio and firm levels.Design/methodology/approachA theoretical model is used to decompose the variance of stock returns into two volatility and two covariance terms by using a conditional Fama-French three-factor model. This study adopts portfolio analysis and Fama-MacBeth cross-sectional regression to examine the relationship between components of idiosyncratic risk and expected stock returns.FindingsThe portfolio analysis results show that volatility terms are negatively related to expected stock returns, and alpha risk has the most significant relationship with stock returns. On the contrary, covariance terms have positive relationships with expected stock returns at the portfolio level. Furthermore, the results of the Fama-MacBeth cross-sectional regression show that only alpha risk can explain variations in stock returns at the firm level. Another finding is that when volatility and covariance terms are excluded from idiosyncratic volatility, the relation between idiosyncratic volatility and stock returns becomes weak at the portfolio level and disappears at the firm level.Originality/valueThis is the first study that examines the relations between all the components of idiosyncratic risk and expected stock returns in equal-weighted and value-weighted portfolios. This research also suggests covariance terms of idiosyncratic volatility as new predictors of stock returns at the portfolio level. Moreover, this paper contributes to the idiosyncratic risk literature by examining whether all the four additional components explain all the systematic patterns included in the unconditional idiosyncratic risk.