What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce

55 Pages Posted: 27 Jun 2016 Last revised: 13 May 2018

See all articles by David A. Lesmond

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Xuhui (Nick) Pan

University of Oklahoma

Roberto Stein

University of Nebraska at Lincoln - Department of Finance

Yihua Zhao

Tulane University - A.B. Freeman School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: May 19, 2017

Abstract

We theoretically establish a market microstructure bias embedded in the estimate of industry-adjusted idiosyncratic variance and empirically show that the bid-ask spread eliminates the observed time trend in aggregate idiosyncratic variance (Campbell, Lettau, Malkiel, and Xu, 2001). These results are robust across various risk-based measures of idiosyncratic variance and through time. Two natural experiments illustrate that an exogenous shock to the bid-ask spread is associated with a subsequent decline in the aggregate idiosyncratic variance. The microstructure hypothesis dominates any of the alternative explanations, including profitability, earnings shocks, growth options, or retail trading for the trend in idiosyncratic variance.

Keywords: Aggregate Firm-Level Variance, Trend, Bid-Ask Spread, Decimalization, Odd-Eighth Quotes

JEL Classification: G10, G12

Suggested Citation

Lesmond, David A. and Pan, Xuhui (Nick) and Stein, Roberto and Zhao, Yihua, What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce (May 19, 2017). Available at SSRN: https://ssrn.com/abstract=2801215 or http://dx.doi.org/10.2139/ssrn.2801215

David A. Lesmond (Contact Author)

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)

Xuhui (Nick) Pan

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States

Roberto Stein

University of Nebraska at Lincoln - Department of Finance ( email )

Lincoln, NE 68588-0490
United States

Yihua Zhao

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

7 McAlister Drive
New Orleans, LA 70118
United States

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