Idiosyncratic Volatility and Liquidity Costs
46 Pages Posted: 19 Feb 2009
Date Written: January 22, 2009
We examine the cross-sectional relation between idiosyncratic volatility (IV) and stock returns and find the results of AngHodrickXingZhang (2006) are critically dependent on the occurrence of zero returns that reflects an inflated measurement of IV. Specifically controlling for liquidity costs engendered in both the percentage of zero returns and the more direct bid-ask spread removes the ability of IV to predict future returns, contrary to SpiegelWang (2005) and Ang et al. (2006). Examining external shocks to liquidity due to reductions in the stated quotes after 1997 and 2001, shows a reduction in the occurrence of zero returns that is accompanied by a significant reduction in the pricing ability of IV. Restricting our analysis to those firms that experience less than 5\% zero returns during the period 1983 to 1996, when the overall pricing ability of IV is at a peak, shows no ability of IV to predict returns. The percentage of zero returns and its affect on IV measurement appears to be a missing component in the ongoing analysis of the pricing of IV.
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