Trend and Reversal of Idiosyncratic Volatility Revisited
Critical Finance Review
57 Pages Posted: 14 Feb 2019 Last revised: 3 Nov 2020
Date Written: March 25, 2019
We reexamine the evolution of the idiosyncratic volatility (IV) of US firms between 1962 and 2016. We theoretically identify three fundamental drivers for the IV: market concentration, average variance, and average correlation. Exploring the separate impacts of these drivers on IV, we find that most of the increase in IV between 1960 and 2000 documented in earlier studies is a result of microstructural biases contained in the daily returns. Consequently, the subsequent introduction of quote decimalization in 2001 caused the reversal of IV. We conclude that studies analyzing volatilities and correlations using daily data from before 2001 should be carefully revisited.
Keywords: Idiosyncratic Volatility, Measurement Error, Bid-Ask Bounce, Asynchronicity
JEL Classification: G11, G12, G14
Suggested Citation: Suggested Citation