Rethinking Idiosyncratic Volatility: Is it Really a Puzzle?
Posted: 2 Jul 2008 Last revised: 25 Jan 2009
Date Written: 2008
In their paper, Ang, Hodrick, Xing, and Zhang [AHXZ (2006)] show that idiosyncratic volatility [Ivol] is inversely related to future stock returns: low Ivol stocks earn higher returns than do high Ivol stocks. The main contribution of this paper is to provide evidence that it is the month to month changes in Ivol that produce AHXZ's results. More specifically, a portfolio of stocks that move from Quintile 1 (low Ivol) to Quintile 5 (high Ivol) earns an average risk-adjusted return of 5.36% per month in the month of the change. Whereas, a portfolio of stocks that move from the highest to the lowest Ivol quintiles earns -0.85% per month in the month of the change. Eliminating all firm-month observations with Ivol quintile changes, I find, opposite to the results of AHXZ, that low Ivol stocks consistently earn lower returns than do high Ivol stocks. I find that many of the extreme changes in Ivol are related to business events. In general, the pattern usually observed is that an announcement or an event increases uncertainty about a stock and hence, its Ivol increases. After the event, uncertainty is resolved and then the stock returns to a lower Ivol quintile.
Keywords: Idiosyncratic Volatility, Stock returns
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