The Effect of COVID-19 on the Relationship between Idiosyncratic Volatility and Expected Stock Returns

Seyed Reza Tabatabaei Poudeh,Sungchul Choi,Chengbo Fu

doi:10.3390/risks10030057

Seyed Reza Tabatabaei Poudeh, Sungchul Choi + Show 1 more

Open Access

https://doi.org/10.3390/risks10030057

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Publication Date: Mar 3, 2022

License type: CC BY 4.0

Affiliation: University of Northern British Columbia

Abstract

This study examines the effect of the COVID-19 pandemic on the relationship between idiosyncratic volatility and expected stock returns. Using daily stock return data in the US market from the Center for Research in Security Prices (CRSP), we estimate monthly idiosyncratic volatility and investigate the effect of the COVID-19 pandemic at the portfolio and firm level. The results of portfolio analysis and cross-sectional regression show that the relationship between idiosyncratic volatility and subsequent stock returns switches from negative to positive during the pandemic period. Furthermore, we find that the relationship is robust to skewness for the “before the pandemic” and “after pandemic” periods. On the contrary, when we control for the one-month return reversal, the effect of idiosyncratic volatility on the subsequent stock returns becomes insignificant in both periods. Therefore, the short-term return reversal effect is the underlying reason for the relationship switching from negative to positive in the pandemic period. Our results are beneficial for investors and researchers.

Highlights

The COVID-19 pandemic, reported for the first time in December 2019, has influenced human life and the economy all around the world
The main goal of this study is to examine the relationship between subsequent stock returns and idiosyncratic volatility before and during the COVID-19 pandemic at the portfolio and firm level
Stocks are sorted into quintile portfolios based on idiosyncratic volatility

Summary

Introduction

The COVID-19 pandemic, reported for the first time in December 2019, has influenced human life and the economy all around the world. Announced COVID-19 as a global phenomenon on 11 March 2020 (WHO 2020). Among over 170 affected countries, the number of confirmed cases is the highest in the US. By the end of January 2020, it was declared an ‘emergency of international concern’, which sounded an alarm across the globe, and it was officially declared a pandemic mid-March, 2020. Europe was declared as the epicenter of the pandemic and it quickly spread to the USA, eventually leading them to become a country with the highest number of affected people. A pandemic of this size and speed directly affects the economy and stock market

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