The pricing of idiosyncratic volatility: An Australian study

Abstract

This study examines the importance of idiosyncratic volatility in asset pricing for Australian stock returns from January 2002 to December 2010. Inspired by work from the early 1990s which found that portfolios constructed to mimic common risk factors explained significant variations in US stock returns, we construct an idiosyncratic volatility mimicking factor to explore the explanatory power of this factor in the Australian stock market. Our results indicate that (a) the idiosyncratic volatility mimicking factor is priced and positively related to the stock returns for the sample period, (b) the explanatory power of the idiosyncratic volatility mimicking factor remains robust in both time-series and cross-sectional analysis, and (c) big size stocks are systematically riskier than small size stocks.JEL Classification: G12

Is idiosyncratic risk ignored in asset pricing: Sri Lankan evidence?

“…Finally, study concludes that idiosyncratic volatility is an equally important factor similar to market, size and value factors in pricing Colombo stock exchange for the study sample period. The study findings are in line with Liu and Di Iorio [37] findings in Australian context. Hence, investor should compensate for holding idiosyncratic risk stocks in the portfolio.…”

“…Fama-MacBeth's cross-sectional regression of two-factor, three-factor, and four-factor model with idiosyncratic volatility factor found that idiosyncratic volatility is negatively related to the expected portfolio returns for MC-and IVOL-based portfolios, whereas idiosyncratic volatility is positively related to the expected portfolio returns for PBbased portfolio. Market return is also important factor that explains risk return relationship, and it is related negatively to the excepted portfolio returns for all MC-and PB-based portfolios, whereas it is positive for IVOL-based portfolios, and findings are similar to Liu and Di Iorio [37] findings in Australian context. Fama-MacBeth's cross-sectional regression confirms that three-factor model with idiosyncratic volatility is equally significant as Fama-French's three-factor model in explaining risk return relationship.…”

“…Similarly, other set of studies by Ang et al [9,10], Guo and Savickas [11], Frieder and Jiang [12], Chua et al [13] and Peterson and Smedeman [36] found that idiosyncratic volatility is negatively related to the expect stock returns. Recent study by Liu and Di Iorio [37] in Australian context finds a positive relationship between the expected returns and idiosyncratic volatility. The study also finds that idiosyncratic factor is very much significant in explaining returns in both time series and cross-sectional set-up.…”

Corporate Hedging and the High Idiosyncratic Volatility Low Return Puzzle

“…They caution that the idiosyncratic volatility puzzle documented in developed markets may not apply to emerging stock markets. In a recent study, Liu and Di Lorio () find a positive relation between idiosyncratic volatility and stock average returns for Australian stocks. In sum, prior studies focus mainly on errors‐in‐variable and measurement error problems as empirical explanations for the Ang et al .…”

“…They caution that the idiosyncratic volatility puzzle documented in developed markets may not apply to emerging stock markets. In a recent study, Liu and Di Lorio (2015) find a positive relation between idiosyncratic volatility 1 In value-weighted portfolios, winner stocks receive heavier weighting than loser stocks, such that return reversal by winner stocks overshadow that of loser stocks. This causes low subsequent value-weighted return.…”