Incomplete Information, Idiosyncratic Volatility and Stock Returns

31 Pages Posted: 17 Mar 2009 Last revised: 17 Aug 2010

See all articles by Julien Hugonnier

Julien Hugonnier

Swiss Federal Institute of Technology Lausanne - Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Tony Berrada

University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute

Multiple version iconThere are 3 versions of this paper

Date Written: March 17, 2009

Abstract

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

Hugonnier, Julien and Berrada, Tony, Incomplete Information, Idiosyncratic Volatility and Stock Returns (March 17, 2009). 23rd Australasian Finance and Banking Conference 2010 Paper. Available at SSRN: https://ssrn.com/abstract=1361485 or http://dx.doi.org/10.2139/ssrn.1361485

Julien Hugonnier

Swiss Federal Institute of Technology Lausanne - Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL Dorigny
Extranef
Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/hugonnier

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Tony Berrada (Contact Author)

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, 1211
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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