Idiosyncratic Volatility, Conditional Liquidity and Stock Returns
32 Pages Posted: 19 Jan 2016
Date Written: January 2016
There is strong evidence showing that stocks with higher levels of idiosyncratic risk provide relatively lower returns than stocks with lower levels of it. This paper points out that this negative idiosyncratic risk - expected returns relation is not pervasive over time, and provides a plausible explanation for its time-varying nature. Our results suggest that following recessions, the conditional pricing of liquidity creates a correction in prices of the high idiosyncratic volatility stocks that persists up to 10 months. As a result, the negative relation between idiosyncratic risk and expected returns is not observed following recessions.
Keywords: Idiosyncratic risk, idiosyncratic volatility anomaly, regime switching model, flight to liquidity
JEL Classification: G12
Suggested Citation: Suggested Citation