Abstract
The well-documented negative association between idiosyncratic volatility (IV) and stock returns is puzzling if investors are risk-averse. We show that this anomaly is also prominent in the Chinese stock market. We attempt to explain the IV anomaly by using the key theories suggested by the literature, such as the lottery effect, arbitrage asymmetry, prospect theory, return reversals and more. None of these competing theories is able to justify the IV anomaly in China. Given that the Chinese stock market possesses both short selling constraints and heterogeneous beliefs, we employ resale option theory as a way to explain the IV puzzle. We find that the resale option value is consistently related to the IV effect in China, and that the explanatory power of the resale option value for the IV anomaly survives a range of robustness tests.
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