Incomplete Information, Idiosyncratic Volatility and Stock Returns
31 Pages Posted: 17 Mar 2009 Last revised: 17 Aug 2010
Date Written: March 17, 2009
This paper proposes and tests a model of firm valuation under incomplete information that explains the ambiguous relation between idiosyncratic volatility and stock returns. Specifically, we show that, when investors have incomplete information, expected returns as measured by an econometrician deviate from the CAPM by including a term that is the product of the stock's \id volatility and the investors' aggregated forecast errors. If investors are biased then this term is on average non zero and generates a theoretical relation between idiosyncratic volatility and expected stocks returns. Relying on forecast revisions from the I/B/E/S Detail files we construct a new variable that proxies for this term and show that this variable explains a significant part of the empirical relation between idiosyncratic volatility and stock returns.
Keywords: Incomplete information, idiosyncratic volatility, q theory of investment
JEL Classification: G12, D83, D92
Suggested Citation: Suggested Citation