Idiosyncratic Return Volatility in the Cross-Section of Stocks
49 Pages Posted: 18 Apr 2011
There are 2 versions of this paper
Do Hedge Funds Reduce Idiosyncratic Risk?
Date Written: April 2011
Abstract
This paper uncovers the changes in the cross-sectional distribution of idiosyncratic volatility of stocks over the period 1963--2008. The contribution of the top decile to the total market idiosyncratic volatility increased, while the contribution of the bottom decile decreased. We introduce a simple theoretical model showing that larger capital of Long/Short-Equity funds further exacerbates large idiosyncratic shocks but attenuates small idiosyncratic shocks. This effect is stronger for more illiquid stocks. Time-series and cross-sectional results are consistent with the predictions of the model. The results are robust to industry affiliation, stock liquidity, firm size, firm leverage, as well as sign of price change. These findings highlight the roll of hedge funds and other institutional investors in explaining the dynamics of extreme realizations in the cross-section of returns.
Keywords: Hedge funds, idiosyncratic risk, limits to arbitrage
JEL Classification: G11, G12
Suggested Citation: Suggested Citation
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