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

58 Pages Posted: 1 Jul 2017  

Nicole Branger

University of Muenster - Finance Center Muenster

Hendrik Hülsbusch

University of Muenster - Finance Center Muenster

T. Frederik Middelhoff

University of Muenster - Finance Center Muenster

Date Written: June 29, 2017

Abstract

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 innovations in a very general setting. Under the assumption of IVOL carrying a positive price of risk (Merton (1987)) we resolve 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

Branger, Nicole and Hülsbusch, Hendrik and Middelhoff, T. Frederik, Idiosyncratic Volatility, Its Expected Variation, and the Cross-Section of Stock Returns (June 29, 2017). Available at SSRN: https://ssrn.com/abstract=2995069

Nicole Branger

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Hendrik Hülsbusch

University of Muenster - Finance Center Muenster ( email )

Schlossplatz 2
Muenster
Germany

T. Middelhoff (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Schlossplatz 2
Muenster
Germany

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