Tests of Idiosyncratic Risk: Informed Trading Versus Noise and Arbitrage Risk

Abstract:     
The finance literature has provided different views on idiosyncratic risk. It may reflect informed trading, noise trading, or limits to arbitrage. We examine the relationship of idiosyncratic volatility with several alternative equity mispricing measures in order to assess the validity of the alternative interpretations of idiosyncratic risk. We find that the level of mispricing declines with idiosyncratic volatility supporting the notion that greater levels of firm-specific risk reflect greater participation of informed traders in the market for the stock. However, we also find that the relationship is U-shaped, with mispricing rising with idiosyncratic risk for stocks with high levels of idiosyncratic volatility. Our results indicate that this increase of mispricing for highly volatile stocks is attributed to both noise trading and arbitrage risk.

Number of Pages in PDF File: 57

Keywords: Idiosyncratic volatility, Market efficiency, Noise trading, Arbitrage risk

JEL Classification: G12, G14

working papers series