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

61 Pages Posted: 6 Jun 2017 Last revised: 3 Jul 2017

See all articles by David A. Lesmond

David A. Lesmond

Tulane University - A.B. Freeman School of Business

Xuhui (Nick) Pan

Tulane University

Yihua Zhao

Tulane University - A.B. Freeman School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: June 5, 2017

Abstract

A number of competing explanations have been offered as a rationale for the trend in idiosyncratic variance that has been experienced over the past four decades. We establish a theoretical model linking a market microstructure bias with the industry-adjusted idiosyncratic variance (Campbell, Lettau, Malkiel, and Xu, 2001) or the risk-adjusted idiosyncratic variance. Using this model’s predictions, we empirically show that the bid-ask spread eliminates the time trend in aggregate idiosyncratic variance. These results are robust across various exchanges, across various risk-based measures of idiosyncratic variance, and through time. Two natural experiments demonstrate 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 uncertainty about profitability, earnings shocks, or growth options, for the trend in idiosyncratic variance.

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

JEL Classification: N10, G15, G10

Suggested Citation

Lesmond, David A. and Pan, Xuhui (Nick) and Zhao, Yihua, What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce (June 5, 2017). Paris December 2017 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=2981139 or http://dx.doi.org/10.2139/ssrn.2981139

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
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504-865-5665 (Phone)
504-865-6751 (Fax)

Xuhui (Nick) Pan

Tulane University ( email )

7 McAlister Dr.
New Orleans, LA 70118
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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