The Idiosyncratic Volatility-Return Relation in a Model with Asymmetric Information
56 Pages Posted: 7 May 2020 Last revised: 2 Feb 2022
Date Written: August 1, 2021
We show that the negative relation between idiosyncratic volatility (IVOL) and equity returns
exists only among firms with low profitability and high uncertainty about profitability.
We propose an incomplete information model in which agents cannot disentangle systematic
from idiosyncratic noise. While not priced directly, idiosyncratic volatility affects expected
returns by lowering the signals’ accuracy, which decreases the factor loading on the priced
systematic risk and yields the negative IVOL-return relation. The model predicts that this
negative relation to be the strongest among under-performing firms with highly uncertain
profitability because the contamination strengthens when uncertainty is high. When applied
to US equity data, the model explains 86% of the negative IVOL-return relation.
Keywords: Idiosyncratic volatility puzzle, Bayesian updating, asymmetric signal precision, firm underperformance
JEL Classification: G12, G14
Suggested Citation: Suggested Citation