Idiosyncratic Volatility and Liquidity Costs
45 Pages Posted: 22 Mar 2009
Date Written: March 18, 2009
We examine the cross-sectional relation between idiosyncratic volatility (IV) and stock returns and propose that the percentage of zero returns and its effect on IV measurement is a missing component in the ongoing analysis of the pricing of IV. We find the results of Spiegel and Wang (2005) and Ang, Hodrick, Xing, and Zhang (2006) are critically dependent on the occurrence of zero returns, yet because these studies do not specifically account for the occurrence of zero returns, measurements of IV are inflated. We examine external shocks to liquidity due to reductions in the stated quotes after 1997 and 2001 and find that a significant reduction in the occurrence of zero returns accompanies 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 peaks, we find no ability of IV to predict returns. Controlling for the 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.
Keywords: Cross-Sectional Return, Idiosyncratic Volatility, Asset Pricing Model, Zero Returns, Bid-Ask Spread, Liquidity Costs
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