Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility

50 Pages Posted: 18 Mar 2010

See all articles by Yufeng Han

Yufeng Han

University of North Carolina (UNC) at Charlotte - Finance

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Date Written: January 15, 2010

Abstract

We examine the cross-sectional relation between idiosyncratic volatility and stock returns and propose that the joint effect of the percentage of zero returns, that affects the loading on the systematic risk factors, and the bid-ask spread, that inflates the variance of the returns, biases the estimate of idiosyncratic volatility and the resulting pricing ability of idiosyncratic volatility. We model the microstructure influence on returns and derive a closed-form solution for the bias in the estimated idiosyncratic volatility. Motivated by this theory, our empirical results show that controlling for the liquidity costs on the estimation of idiosyncratic volatility diminishes to insignificance the ability of idiosyncratic volatility estimates to predict future returns. We confirm our findings by examining external shocks to liquidity, due to reductions in the stated quotes after 1997 and the decimalization of quotes in 2001, and find a significant reduction in the pricing ability of idiosyncratic volatility. Finally, minimizing liquidity’s influence on the estimated idiosyncratic volatility, by orthogonalizing the percentage of zero return and spread effects on the estimated idiosyncratic volatility, demonstrates that the resulting idiosyncratic volatility estimate has little pricing ability.

Keywords: Cross-Sectional Return, Idiosyncratic Volatility, Zero Returns, Bid-Ask Spread

JEL Classification: K11

Suggested Citation

Han, Yufeng and Lesmond, David A., Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility (January 15, 2010). Available at SSRN: https://ssrn.com/abstract=1571758 or http://dx.doi.org/10.2139/ssrn.1571758

Yufeng Han (Contact Author)

University of North Carolina (UNC) at Charlotte - Finance ( email )

9201 University City Boulevard
Charlotte, NC 28223
United States

David A. Lesmond

Tulane University - A.B. Freeman School of Business ( email )

7 McAlister Drive
511 Goldring-Woldenberg Hall
New Orleans, LA 70118
United States
504-865-5665 (Phone)
504-865-6751 (Fax)

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