47 Pages Posted: 15 Mar 2010
Date Written: February 28, 2010
This paper reconciles the conflicting evidence on the cross-sectional pricing of idiosyncratic risk. Some studies find a negative relation, while others document a positive relation between idiosyncratic volatilities and future returns on individual stocks. In contrast to the common practice of applying total idiosyncratic volatilities, we decompose the volatility into long- and short-run components. As a result, we find that stocks with high long-run idiosyncratic risks have large future returns. On the contrary, the short-run idiosyncratic risk component is negatively related to stock returns. This finding suggests that different relations documented in the current literature depend on the dominance of the long- versus the short-run components of the idiosyncratic risk reflected in the particular measure used by a study. Our results are robust to model specifications, sample periods, different samples of stocks, and the possible January effect.
Keywords: APT model, Cross-sectional returns, Decomposition, Error-in-variables, Idiosyncratic risk, January effect, Long-run volatility, Short-run volatility
JEL Classification: G12
Suggested Citation: Suggested Citation
Cao, Xuying and Xu, Yexiao, Long-Run Idiosyncratic Volatilities and Cross-Sectional Stock Returns (February 28, 2010). Available at SSRN: https://ssrn.com/abstract=1569945 or http://dx.doi.org/10.2139/ssrn.1569945