Expected Volatility, Unexpected Volatility, and the Cross‐section of Stock Returns

Abstract

The existing literature finds conflicting results on the cross-sectional relation between expected returns and idiosyncratic volatility. We contend that at the firm level, the sample correlation between unexpected returns and expected idiosyncratic volatility can cloud the true relation between the expected return and expected idiosyncratic volatility. We show strong evidence that unexpected idiosyncratic volatility is positively related to unexpected returns. Using unexpected idiosyncratic volatility to control for unexpected returns, we find expected idiosyncratic volatility to be significantly and positively related to expected returns. This result holds after controlling for various firm characteristics, and it is robust across different sample periods. Copyright (c) 2010 The Southern Finance Association and the Southwestern Finance Association.

Idiosyncratic Volatility and Cross-section of Stock Returns: Evidences from India

“…The relationship is positive, indicates that a 1% increase in EI will lead to 0.55% increase in expected stock returns. The results are consistent with the study of Spiegel and Wang (2005), Fu (2009) andChua et. al., (2010), as they documented a significant positive relationship between expected returns, EI and UI.…”

“…The parameter is statistically significant at 5% level of significance level; clearly indicates that the EI explain the cross-section of stock returns significantly in Indian market. These findings are consistent with Fu (2009) andChua et. al., (2010).…”

“…The study finds a significant positive relationship between EI and stocks expected returns, that is consistent with studies of Merton (1987), Fu (2009) andChua et. al., (2010) which reported the significant robust relationship between EI and expected returns.…”

Short-sale constraints and the idiosyncratic volatility puzzle: An event study approach

“…Using alternative measures of firm-specific volatility, Malkiel and Xu (2006), Spiegel and Wang (2006), Chua, Goh, and Zhang (2007), and Diavatopoulos, Doran, and Peterson (2008), and Fu (2009) however, show that once January is excluded, the negative volatility-return relation is fairly robust. This is because high idiosyncratic volatility stocks, particularly the small ones, earn abnormally high returns in January.…”

“…Fu (2009) estimates the expected idiosyncratic volatility from exponential GARCH models. Chua, Goh, and Zhang (2007) find the expected component of idiosyncratic volatility, and Diavatopoulos, Doran, and Peterson (2008) estimate idiosyncratic volatility from the implied volatility of options.…”