Idiosyncratic Volatility, Its Expected Variation, and the Cross-Section of Stock Returns

We show that the widely documented negative relation between idiosyncratic volatility (IVOL) and expected returns can be explained by the mean reversion of stocks' idiosyncratic volatilities. We use option-implied information to extract the mean reversion speed of IVOL in an almost model-free fashion. This allows us to identify stocks for which past IVOL is a bad proxy for expected IVOL. These stocks solely drive the negative relation, and a long--short portfolio earns a monthly risk-adjusted return of 2.74%, on average. In a horse race, the mean reversion speed is superior to prominent competing explanations of the IVOL puzzle.

Keywords: Options, Stock Returns, Idiosyncratic Volatility, Volatility-of-Volatility

JEL Classification: G12, G13

Suggested Citation: Suggested Citation

Branger, Nicole and Hülsbusch, Hendrik and Middelhoff, Frederik T., Idiosyncratic Volatility, Its Expected Variation, and the Cross-Section of Stock Returns (January 29, 2018). Paris December 2018 Finance Meeting EUROFIDAI - AFFI, Available at SSRN: https://ssrn.com/abstract=2995069 or http://dx.doi.org/10.2139/ssrn.2995069