Idiosyncratic Volatility Puzzle Research Articles

A Revisit on Idiosyncratic Volatility Puzzle: Evidence from Sri Lanka

A Revisit on Idiosyncratic Volatility Puzzle: Evidence from Sri Lanka

Changes in Market Uncertainty and Profitability of Idiosyncratic Volatility Anomaly in Korea

Purpose - The idiosyncratic volatility (IVOL) puzzle is the anomaly that lower IVOL stocks earn higher future returns. We examine if global market uncertainty and market fear affect idiosyncratic volatility anomaly profits in Korea. Design/methodology/approach - Change in market uncertainty and investor fear is measured by change in the volatility index (VIX). Stocks are sorted into quintile portfolios based on their IVOLs in each month. To measure the anomaly profit, the return spread between two extreme portfolios is computed. Risk-adjusted returns are also calculated relative to capital asset pricing model (CAPM) and the Fama and French model. Then, we compare the difference of the IVOL investing profits in the decreasing and increasing VIX periods. Findings - We find that in the months following a decrease in VIX, stocks with low IVOLs earn 2.5% higher profits than stocks with high IVOLs. However, no such anomaly arises in the months following an increase in the VIX. Research implications or Originality - This result implies that mispricing is more significant when investors’ fears regarding market uncertainty are abated. Also, investors can obtain the IVOL anomaly returns by buying low IVOL stocks when the VIX decreases and selling them the following month. This finding suggests that the Korean stock market is integrated with the global market.

Extreme returns and the idiosyncratic volatility puzzle: African evidence

ABSTRACTWe examine the cross-sectional relationship between the expected stock return and both the maximum daily return (MAX) and the idiosyncratic volatility (IVOL) in the five largest emerging African stock markets over the period from 2001 to 2015. First, we find that there is a robust and significantly negative MAX effect in the pooled African stock markets. Second, though we initially document a negative IVOL effect, it disappears after controlling for MAX. Finally, the negative MAX effect is only significant in the small-SIZE, high-illiquidity and high-skewness portfolios. Our results suggest risk-seeking behaviour among African investors similar to that in other parts of the world.

In Search of Systematic Risk and the Idiosyncratic Volatility Puzzle in the Corporate Bond Market

We provide time-series and cross-sectional evidence on the significance of a risk-return tradeoff in the corporate bond market. We find a significantly positive intertemporal relation between expected return and risk in the bond market and the time-series predictability is driven by aggregate systematic risk instead of aggregate idiosyncratic risk. We also propose a new measure of systematic risk for corporate bonds and find a positive link between systematic risk and the cross-section of future bond returns. We provide an explanation for the significance of systematic (idiosyncratic) risk based on different investor preferences and informational frictions in the bond (equity) market. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Tail risk and expected stock returns around the world

In this study, we construct three proxies for tail risk observed in 39 markets between 1980 and 2015 to examine its effects on global pricing: TRKJ, following Kelly and Jiang (2014), TRVZ, following Van Oordt and Zhou (2016), and TRHL, following Huang et al. (2012) and Long et al. (2018). Both the portfolio analyses and Fama-MacBeth regressions show that TRKJ has no pricing effect in the international markets, but both TRVZ and TRHL has a negative relationship with future stock returns, especially in developed markets, which is inconsistent with common sense assumptions regarding the risk-return tradeoff. This negative relationship can be explained by the “idiosyncratic volatility puzzle” in the international markets other than the U.S. market. Moreover, a detailed analysis of the U.S. market suggests that the negative tail-risk–stock returns relationship in that market cannot be explained by the momentum effect, skewness, heterogeneous beliefs, the liquidity factor, leverage, or profitability, leaving an unsolved puzzle, which we call the “tail risk puzzle”

Flight-to-liquidity: Evidence from China's stock market

In an order-driven and strictly regulated stock market, illiquidity risks' effects on asset pricing should be highlighted, particularly in such extreme market conditions as those in China. This paper utilizes panel data from China's stock market in an attempt to answer whether the illiquidity risk in various dimensions—including price impacts, the transaction speed, trading volume, transaction costs, and asymmetric information—can explain stock returns. We find that almost all dimensions of stock illiquidity are positively associated with excess stock returns. More importantly, smaller, less-liquid stocks suffer more liquidity costs, providing a strong evidence for “flight-to-liquidity.” Additionally, the transaction costs and asymmetric information, denoted by bid-ask spreads, robustly account for these illiquidity effects on stock pricing and differ from the findings in the U.S. market. We also find that the “flight-to-liquidity” can partially explain the idiosyncratic volatility puzzle, investors' gambling, and herding psychologies. This study provides substantial policy implications in regulation and portfolio management for emerging markets.

Have Hedge Funds Solved the Idiosyncratic Volatility Puzzle?

While it is established that idiosyncratic volatility has a negative impact on the cross-section of future stock returns, the relationship between idiosyncratic volatility and future hedge fund returns is largely unexplored. We document that hedge funds with high idiosyncratic volatility outperform and this pattern is explained by the positive return effect of idiosyncratic volatility in their equity portfolio holdings. Hedge funds select stocks wisely by picking high-volatility stocks when they are undervalued and shying away from high-volatility stocks when they are overvalued or display lottery-like payoffs. They also trade derivatives in a way to profit from the positive volatility effect.

Decomposition and Evaluation on the Determinants of the Idiosyncratic Volatility Puzzle in Korea Stock Market

Decomposition and Evaluation on the Determinants of the Idiosyncratic Volatility Puzzle in Korea Stock Market

고유변동성 이상 현상의 강건성에 관한 검토

고유변동성 이상 현상의 강건성에 관한 검토

Abnormal Returns and Idiosyncratic Volatility Puzzle: Evidence from the Chinese Stock Market

ABSTRACTThe well-documented idiosyncratic volatility anomaly indicates the stocks with higher idiosyncratic volatility tend to have lower returns. Using different models to estimate abnormal return (i.e. alpha), we show that in the Chinese stock market, the IVOL-return relation is negative among stocks with negative abnormal returns but positive among stocks with positive abnormal returns. A possible explanation is that when we take the expected return as the reference point, different signs of abnormal returns can be viewed as gains and losses. Under prospect theory, distinct risk attitudes in the domain of gains and losses lead to different IVOL-return relations.

Idiosyncratic Volatility Puzzle: The Role of Assets' Interconnections

The paper investigates the determinants of the idiosyncratic volatility puzzle by allowing linkages across asset returns. The first contribution of the paper is to show that portfolios sorted by increasing indegree computed on the network based on Granger causality test have lower expected returns, not related to idiosyncratic volatility. Secondly, empirical evidence indicates that stocks with higher idiosyncratic volatility have the lower exposition on the indegree risk factor.

Parameter regimes in partial functional panel regression

A new partial functional linear regression model for panel data with time varying parameters is introduced. The parameter vector of the multivariate model component is allowed to be completely time varying while the function-valued parameter of the functional model component is assumed to change over K unknown parameter regimes. Consistency is derived for the suggested estimators and for the classification procedure used to detect the K unknown parameter regimes. Additionally, the convergence rates of the estimators are derived under a double asymptotic differentiating between asymptotic scenarios depending on the relative order of the panel dimensions n and T. The statistical model is motivated by a real data application considering the so-called “idiosyncratic volatility puzzle” using high frequency data from the S&P500.

Lottery preferences and the idiosyncratic volatility puzzle

AbstractWe investigate the empirical implications of investors’ heterogeneous preferences for skewness with respect to the idiosyncratic volatility (IVOL) puzzle, that is, the negative correlation between IVOL and mean returns. We show that the IVOL puzzle is stronger: (1) within stocks held primarily by agents with a preference for lottery‐like payoffs; and (2) during economic downturns, when the demand for lottery‐like payoffs is high. These results support recent theories that suggest lottery preferences could be a significant source of the IVOL puzzle.

Time variation of MAX-premium with market volatility: Evidence from Korean stock market

Korean stock market provides an ideal setting to examine the time-variation of the premium for stocks with a large price jump (MAX) because the market is mostly dominated by individual investors who are more prone to behavioral bias than institutional investors are. We find that investors' overpayment for stocks with high MAX is driven by increased salience of such stocks especially in the period with high uncertainty, measured by high local market volatility. We further find evidence that the negative relation between stock returns and idiosyncratic volatility, which is much stronger for stocks with high MAX than for stocks with low MAX, is more pronounced in the period with high market volatility. Overall, our findings emphasize that when investors have limited attention, attention-grabbing features of high MAX drives the time-variation in the degree of overpayment for stocks with high MAX and helps explain the idiosyncratic volatility puzzle.

The robust “maximum daily return effect as demand for lottery” and “idiosyncratic volatility puzzle”

Abstract We form indexes of overpriced and underpriced stocks by ranking stocks based on the disposition effect and anchoring bias. We document the negative relation between maximum daily return and future returns (MAX effect) is confined to overpriced stocks which make up about half the entire sample. We find that the average cross-sectional correlation between maximum daily return and idiosyncratic volatility is nearly 90%. Consistent with prior studies the idiosyncratic volatility puzzle disappears after controlling for the MAX effect. However, when using a sample with a $5 price breakpoint and controlling for overpriced stocks the idiosyncratic volatility puzzle and the MAX effect are economically and statistically significant.

The Idiosyncratic Volatility Puzzle and its Interplay with Sophisticated and Private Investors

We establish a direct link between the idiosyncratic volatility (IVol) puzzle and the behavior of sophisticated and private investors. To do so, we employ three option-based measures of informed trading and attention data from Google Trends. Our analyses show that the IVol puzzle is particularly driven by a group of overpriced stocks that can be identified by the use of sophisticated trader opinion. Since IVol is no perfect mispricing indicator, the option measures can help to distinguish high-IVol stocks that are overvalued from high-IVol stocks that are not exposed to mispricing. We link the origin of the anomaly to the trading activity of irrational private investors. This supports the intuitive idea that noise trading leads to mispricing which can be exploited by sophisticated investors at the option market.

Idiosyncratic volatility puzzle: influence of macro-finance factors

We analyze the cross-sectional relation between expected idiosyncratic volatility and stock returns. The expected idiosyncratic volatility is conditioned on macro-finance factors as well as traditional asset pricing factors. The macro-finance factors are constructed from a large set of macroeconomic and financial variables. Our results show that the negative relation between expected idiosyncratic volatility and stock returns reverses to a positive one when accounting for the macro-finance effects. Portfolio analysis shows that the positive relation is economically important. The relation between expected idiosyncratic volatility and returns is not affected by business cycle variations. The empirical results are highly robust.

Mispricing, Research Design Choices, and the Idiosyncratic Volatility Puzzle

Mispricing, Research Design Choices, and the Idiosyncratic Volatility Puzzle

Nonlinearity, Return Reversals, Information Flow, and the Idiosyncratic Volatility Puzzle

Nonlinearity, Return Reversals, Information Flow, and the Idiosyncratic Volatility Puzzle

Maxing Out Globally: Individualism, Investor Attention, and the Cross Section of Expected Stock Returns

We examine the role of cultural difference in the pricing of positive extreme returns (MAX) for 47,000 stocks from 42 countries from 1990 to 2012. We find that investors overpay for stocks with high MAX and that MAX-premium, the spread from long-short strategy based on low- and high-MAX stocks, is both statistically and economically significant worldwide. The negative relation between idiosyncratic volatility and expected returns, or idiosyncratic volatility puzzle, exists only for stocks with high MAX, implying that the puzzle may arise from the overpayment for stocks with high MAX and the subsequent return reversal. Consistent with the expectation that overpayment will be stronger for overconfident investors, the MAX-premium is larger in countries with high individualism index (IDV) than it is in countries with low IDV. Furthermore, we find the MAX-premium to be larger and the difference in the MAX-premium between high- and low-IDV countries to be more pronounced when VIX and volatility are high. Our findings suggest that the attention-grabbing feature of stocks with high MAX affects the pricing of extreme positive returns asymmetrically depending on the cultural differences across countries. This paper was accepted by Lauren Cohen, finance.