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Long-Run Idiosyncratic Volatilities and Cross-Sectional Stock Returns

47 Pages Posted: 15 Mar 2010  

Xuying Cao

University of Texas at Dallas - Naveen Jindal School of Management

Yexiao Xu

University of Texas at Dallas - School of Management

Date Written: February 28, 2010

Abstract

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

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

Xuying Cao

University of Texas at Dallas - Naveen Jindal School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States

Yexiao Xu (Contact Author)

University of Texas at Dallas - School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-6703 (Phone)

HOME PAGE: http://www.utdallas.edu/~yexiaoxu

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