Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility Around the World

Abstract:     
Across 23 developed international markets, it has been shown that the difference in average returns for the extreme quintile portfolios sorted on idiosyncratic volatility yields an abnormal performance in excess of -1.0% per month. We extend the analysis of idiosyncratic volatility to 45 world markets, comprising 23 developed and 22 emerging markets, and find that the pricing ability of idiosyncratic volatility is critically dependent on bid-ask errors in security returns that affects the estimation of idiosyncratic volatility. Once we extract measurement errors in prices caused by the bid-ask spread we find little evidence in the pricing ability for idiosyncratic volatility. The effect is substantial with almost half of the abnormal performance of idiosyncratic volatility due to measurement errors in prices. This evidence is suggestive of a liquidity bias in the estimate of idiosyncratic volatility and highlights the importance of controlling for liquidity's effect on returns in international asset pricing.

Number of Pages in PDF File: 57

Keywords: Cross-Sectional Return, International Markets, Idiosyncratic Volatility, Bid-Ask Spread

JEL Classification: C12

working papers series