Idiosyncratic Volatility, Its Expected Variation, and the Cross-Section of Stock Returns
59 Pages Posted: 1 Jul 2017 Last revised: 5 Jun 2018
Date Written: January 29, 2018
We offer a novel perspective on the negative relation between idiosyncratic volatility (IVOL) and expected returns. We show that the IVOL puzzle is largely driven by a mean-reversion behavior of the stocks' volatilities, which is not captured by a simple historic measure of IVOL. In doing so, we make use of option implied information to extract the expected mean-reversion speed of IVOL in an almost model-free fashion. Together with the current level of IVOL this method allows us to identify stocks' expected IVOL changes in a very general setting. Under the assumption of IVOL carrying a positive price of risk (Merton (1987)) we offer a explanation for the puzzle. In a horse race we show that the mean-reversion speed is superior to the most prominent competing explanations. All our findings are robust to different measures of IVOL and various stock characteristics.
Keywords: Options, Stock Returns, Idiosyncratic Volatility, Volatility-of-Volatility
JEL Classification: G12, G13
Suggested Citation: Suggested Citation