The Idiosyncratic Volatility-Return Relation in a Model with Asymmetric Information

56 Pages Posted: 7 May 2020 Last revised: 2 Feb 2022

See all articles by Xuhui (Nick) Pan

Xuhui (Nick) Pan

University of Oklahoma

Bharat Raj Parajuli

Monash University

Petra Sinagl

University of Iowa - Department of Finance

Date Written: August 1, 2021

Abstract

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

Pan, Xuhui (Nick) and Parajuli, Bharat Raj and Sinagl, Petra, The Idiosyncratic Volatility-Return Relation in a Model with Asymmetric Information (August 1, 2021). Available at SSRN: https://ssrn.com/abstract=3574790 or http://dx.doi.org/10.2139/ssrn.3574790

Xuhui (Nick) Pan

University of Oklahoma ( email )

307 W Brooks
Norman, OK 73019
United States

Bharat Raj Parajuli

Monash University ( email )

900 Dandenong Road
Caulfield East, VIC, 3145
Australia

Petra Sinagl (Contact Author)

University of Iowa - Department of Finance ( email )

Iowa City, IA 52242-1000
United States

HOME PAGE: http://andrlikova.com

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