Does Idiosyncratic Volatility Proxy for a Missing Risk Factor? Evidence Using Portfolios as Test Assets

Forthcoming at European Financial Management

44 Pages Posted: 12 Mar 2021 Last revised: 14 May 2021

See all articles by David Gempesaw

David Gempesaw

Miami University

Haim Kassa

Miami University

Blerina Bela Zykaj

Clemson University - College of Business

Date Written: May 1, 2021

Abstract

One of the main explanations for the idiosyncratic volatility (IVOL) puzzle (i.e., the negative relation between lagged IVOL and returns) is a missing risk factor. We show analytically that if IVOL proxies for a missing risk factor, then the negative relation between IVOL and returns should persist at the portfolio level. Empirically, we find that the IVOL puzzle disappears when we use well-diversified portfolios as test assets. The IVOL puzzle also weakens after controlling for additional risk factors. Overall, our results suggest that both diversifiable (i.e., true idiosyncratic risk) and non-diversifiable risk play a role in explaining the IVOL puzzle.

Keywords: Idiosyncratic volatility, IVOL puzzle, missing risk factor

JEL Classification: G10, G11, G12

Suggested Citation

Gempesaw, David and Kassa, Haim and Zykaj, Blerina Bela, Does Idiosyncratic Volatility Proxy for a Missing Risk Factor? Evidence Using Portfolios as Test Assets (May 1, 2021). Forthcoming at European Financial Management, Available at SSRN: https://ssrn.com/abstract=3770317 or http://dx.doi.org/10.2139/ssrn.3770317

David Gempesaw (Contact Author)

Miami University ( email )

Oxford, OH 45056
United States

Haim Kassa

Miami University ( email )

800 E. Main St
The Farmer School of Business
Oxford, OH 45056
United States
(513) 529-2057 (Phone)
(513) 556-4891 (Fax)

HOME PAGE: http://fsb.miamioh.edu/kassah

Blerina Bela Zykaj

Clemson University - College of Business ( email )

225 Walter T. Cox Blvd.,
Clemson, SC 29634
United States

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