Idiosyncratic volatility: An indicator of noise trading?

Abstract

We investigate the market efficiency implications of firm-specific return variation measured by absolute idiosyncratic volatility. We find that the absolute idiosyncratic volatility (the variance of the residual from an asset-pricing model) displays a positive and robust relationship to mispricing, which reflects an increasing role of noise traders. Previous literature has produced similar -or opposing -results. We deepen our understanding of the previous conflicting results by showing that 1) market volatility by itself is associated with mispricing, 2) absolute idiosyncratic volatility is associated with mispricing even when controlling for market volatility, 3) the strength of the association between absolute idiosyncratic volatility and mispricing depends on the level of market volatility, and 4) absolute and relative measures of idiosyncratic volatility have opposing associations with mispricing. Our findings contribute to the existing literature by reconciling the mixed results for the relationship between idiosyncratic volatility and mispricing displayed in the previous literature. JEL classification: G12; G14

Leverage structure and stock price synchronicity: Evidence from China

“…Hence stock price synchronicity can be proxied for market informativeness [12,[25][26][27][28]. In addition, idiosyncratic volatility is positively correlated to mispricing [29]. Idiosyncratic volatility can also be used as proxy for mispricing, and findings show that valuation uncertainty does not amplify the profitability premium in the Chinese stock market [30].…”

Is Low-Volatility Investing Sustainable in the SME Stock Market of Korea? A Risk and Return Analysis

“…Our study is interesting in that we link a theoretical prediction to a practical investing strategy. Based on the behavioral theories arguing that the idiosyncratic risk puzzle may be due to mispricing by noise traders such as individual investors [7][8][9], we have chosen a special market-KOSDAQ-the market most aggressively traded by individual investors and where, due to Korean market regulations, the classification of investors of a trade is possible. As predicted, we confirm that this market shows different characteristics relating to the idiosyncratic risk puzzle compared to the KOSPI market, where noise trading is relatively less prevalent.…”

Cross‐shareholding networks and stock price synchronicity: Evidence from China

“…For example, Roll (1988) suggests that the volatility of stock returns would not be totally dependent on fundamental information. The noise trading has been proven to be a potential factor of return volatility (Anbo et al, 2017). It is shown that taking noise trading into consideration, stock price synchronicity does not always vary monotonically with price informativeness (Lee & Liu, 2011).…”