Idiosyncratic Volatility, Its Expected Variation, and the Cross-Section of Stock Returns
61 Pages Posted: 1 Jul 2017 Last revised: 19 Jul 2019
Date Written: January 29, 2018
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