Volatility Puzzle Research Articles

Speculation-Driven Business Cycles

Speculation, in the spirit of Harrison and Kreps [1978], is introduced into a standard real business cycle model. Investors (speculators) hold heterogeneous beliefs about firm growth. Firm ownership, and thus, the firm’s discount factor varies with waves of optimism and leverage. These waves ripple into firm investments in hours. The firm’s discount discount factor links the equity premium and labor volatility puzzles. We obtain an upper bound to the amplification that can be generated by speculation for any model of beliefs -- a factor of 1.5. A calibration based on diagnostic beliefs amplifies hours volatility by a factor of 1.15 and produces a bubble component of 20 percent.

Disagreement, Speculation, and the Idiosyncratic Volatility Puzzle

We propose that speculative trading arising from the joint effect of investor disagreement and short-sale constraints plays an important role in explaining the idiosyncratic volatility (IVOL) puzzle, the correlation among IVOL, market beta and trading volume, and the co-movement of IVOL. Empirical tests show that the return spread between high and low IVOL quintile portfolios is closely related to both aggregate and firm-level disagreement. The common IVOL (CIV) factor is strongly correlated with the aggregate disagreement. The correlation between the IVOL effect and disagreement presents mainly among stocks that are more likely to be short-sales constrained. We provide a mechanism that high aggregate disagreement can lead to more firm-level speculative trading, which is consistent with a factor structure in IVOL and positive correlation among stock beta, the IVOL effect, and the trading volume.

Abnormal returns and idiosyncratic volatility puzzle: An empirical investigation in Vietnam stock market

This paper aims to examine the relation between idiosyncratic volatility (IVOL) and stock returns with full-sample and conditional alpha sub-samples in Vietnam stock market covering the period from...

Duration-Based Stock Valuation: Reassessing Stock Market Performance and Volatility

Using a panel of international government bond data, I construct fixed income portfolios that match the duration of the dividend strips of the corresponding local aggregate stock market index. I find that these bond portfolios have performed as well as -- if not better than -- their stock counterparts in the past half century while exhibiting similar (or even higher) levels of volatility. These results provide a novel perspective on both the equity risk premium and excess volatility puzzles (bubbles). I present several potential explanations, and discuss further the implications for macroeconomics, monetary economics, asset pricing, and corporate finance.

The role of reference-dependent preferences in the idiosyncratic volatility puzzle: Evidence from Korea

In this paper, the role of the reference-dependent preference in the relationship between idiosyncratic volatility and future return was investigated in the Korean stock market from July 1990 to Ju...

A Revisit on Idiosyncratic Volatility Puzzle: Evidence from Sri Lanka

A Revisit on Idiosyncratic Volatility Puzzle: Evidence from Sri Lanka

Why Does the Fed Move Markets so Much? A Model of Monetary Policy and Time-Varying Risk Aversion

We build a new model integrating a work-horse New Keynesian model with investor risk aversion that moves with the business cycle. We show that the same habit preferences that explain the equity volatility puzzle in quarterly data also naturally explain the large high-frequency stock response to Federal Funds rate surprises. In the model, a surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks. The model explains the positive correlation between changes in breakeven inflation and stock returns around monetary policy announcements with long-term inflation news.

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.

Intangible factor and idiosyncratic volatility puzzles

In this paper, we explore whether intangible capital (IC) can help explain idiosyncratic volatility puzzles. The underlying assumption is that firms produce and accumulate IC as part of their normal operations. Investments in IC can either raise a company's future ability to produce or lower its cost of production. The applied model finds empirical support for the hypothesis that IC can help explain idiosyncratic volatility puzzles, especially for firms with higher IC-to-total asset ratios. This paper contributes to existing literature on idiosyncratic volatility puzzles from an IC investment perspective and provides implications for IC on stock markets.

Frictional unemployment with stochastic bubbles

We show that the volatility puzzle in labor economics (Shimer, 2005) stems from the inability of technology shocks to generate sufficient volatility of firm value. We introduce non-fundamental shocks to firm value, akin to bubbles, into an otherwise standard search-and-matching model. When calibrated to stock market data, stochastic bubbles significantly improve the ability of the matching model to quantitatively explain the volatility of the US labor market. An extension with multiple sectors improves the persistence of simulated labor market variables.

A Business Cycle Asset Pricing Model

An asset pricing model is introduced that captures the market, liquidity, credit, and business cycle risks. The explicit incorporation of economic-phase-switching business cycle risks with rational expectations makes the predicted return volatility equal to the observed return volatility. Therefore, the concerns over excessive volatility and equity premium puzzle become insignificant. The risk-return tradeoff dynamic disequilibrium model builds on the equilibrium CAPM, taken as its steady state. It has no worse explanatory power than that of the Fama-French three-factor model and its variants but significantly better out-of-sample predictive power and ex-post S&P 500 portfolio returns over the last 20-year period.

Disagreement with procyclical beliefs and asset pricing

We consider a pure exchange economy with incomplete information in which the expected growth rate of endowment is unobservable. The economy is populated by two investors, one is rational, but the other irrationally believes that the dynamics of endowment exhibit procyclical feature. Such different opinions about the dynamics of endowment process produce persistent disagreement between the investors. We show that model-implied riskfree rate is procyclical. Further, the procyclical beliefs not only explain the excess volatility puzzle, but also help to explain the mixed results about the relationship between the investors’ belief dispersions and stock return. Moreover, we uncover that the rational investor prefers to short stock positions in good times as the degree of the other investor’s irrationality increasing.

Resolving Asset Pricing Puzzles with Price Impact

We solve in closed-form a continuous-time Nash equilibrium model in which a finite number of exponential investors continuously consume and trade strategically with price-impact. Compared to the analogous Pareto-efficient equilibrium model, price-impact has an amplification effect on risk-sharing distortions that helps resolve the interest rate puzzle and the stock-price volatility puzzle. However, price impact has little effect on the equity premium puzzle.

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”

Valuing Equities: Discounting Growth Opportunities, Fearing Inflation

Over the last century (Eretained/P)mean ~ constant while D/P has experienced a long secular decline. If investors cannot simultaneously discount both Eretained and D, examination of the relationships between Eretained/P, D/P and the payoff ratio Eretained/D offers support to the hypothesis that Eretained/P is the priced valuation ratio. A linear Empirical Model (EM) identifies two data variables, the trailing earnings growth (EG) and inflation (cpi), that explain R2 ~ 50% of the variance of Eretained/P. The investor’s decision to sell or hold the shares is governed by the investor’s resistance to Intertemporal Substitution, R = γµ, so the MF-Gordon becomes Eretained/P = γµ - µ . A dynamic Model is obtained using Taylor expansions of the functional relationships µ = µ(EG(t)) and γ = γ(cpi(t)). The Model is calibrated using the EM. The MF-Gordon Model is used to explain the quasi-equality of equities and the long bond (1970:2000), the equity/long bond equity premium and the effect of sentiment on equity prices. The Shiller price volatility puzzle is explained by the adaptive growth expectation which is heavily loaded on the highly volatile trailing earnings growth rate.

Leverage and the Cross‐Section of Equity Returns

ABSTRACTBuilding on theoretical asset pricing literature, we examine the role of market risk and the size, book‐to‐market (BTM), and volatility anomalies in the cross‐section of unlevered equity returns. Compared with levered (stock) returns, unlevered market beta plays a more important role in explaining the cross‐section of unlevered equity returns, even after controlling for size and BTM. The size effect is weakened, while the value premium and the volatility puzzle virtually disappear for unlevered returns. We show that leverage induces heteroskedasticity in returns. Unlevering returns removes this pattern, which is otherwise difficult to address by controlling for leverage in regressions.

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.

The Unemployment Volatility and Wage Inertia Puzzles: The Centrality of Vacancy Posting Costs (to Output)

The Unemployment Volatility and Wage Inertia Puzzles: The Centrality of Vacancy Posting Costs (to Output)