Changes in Market Uncertainty and Profitability of Idiosyncratic Volatility Anomaly in Korea

Abstract

Purpose - The idiosyncratic volatility (IVOL) puzzle is the anomaly that lower IVOL stocks earn higher future returns. We examine if global market uncertainty and market fear affect idiosyncratic volatility anomaly profits in Korea.

Design/methodology/approach - Change in market uncertainty and investor fear is measured by change in the volatility index (VIX). Stocks are sorted into quintile portfolios based on their IVOLs in each month. To measure the anomaly profit, the return spread between two extreme portfolios is computed. Risk-adjusted returns are also calculated relative to capital asset pricing model (CAPM) and the Fama and French model. Then, we compare the difference of the IVOL investing profits in the decreasing and increasing VIX periods.

Findings - We find that in the months following a decrease in VIX, stocks with low IVOLs earn 2.5% higher profits than stocks with high IVOLs. However, no such anomaly arises in the months following an increase in the VIX.

Research implications or Originality - This result implies that mispricing is more significant when investors’ fears regarding market uncertainty are abated. Also, investors can obtain the IVOL anomaly returns by buying low IVOL stocks when the VIX decreases and selling them the following month. This finding suggests that the Korean stock market is integrated with the global market.

Keywords: Anomaly, Idiosyncratic Volatility Puzzle, Korean Stock Market, Mispricing, VIX

JEL Classification: G11, G12