Volatility and the Cross-Section of Equity Returns: Market Frictions vs. Arbitrage Risk
48 Pages Posted: 28 Apr 2020 Last revised: 8 Mar 2021
Date Written: April 3, 2020
IHS Markit data reveals that stocks with high idiosyncratic volatility are far more likely to be hard-to-borrow than low idiosyncratic volatility stocks. When hard-to-borrow stocks are excluded, the relation between idiosyncratic volatility (IVOL) and stock returns disappears. The relation between idiosyncratic volatility and returns is more accurately described as a relation between being hard-to-borrow and stock returns. Arbitrage risk, on the other hand, is far too small to explain mispricing of high IVOL stocks. When the idiosyncratic volatility of portfolios rather than individual stocks is considered, Sharpe ratios of mispriced IVOL portfolios are much greater than the value-weighted market’s Sharpe ratio.
Keywords: Short Selling Fees, Idiosyncratic Volatility, Hard to Borrow Stocks
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