Liquidity Costs, Idiosyncratic Volatility and Expected Stock Returns

42 Pages Posted: 7 Dec 2021

See all articles by Reza Bradrania

Reza Bradrania

University of South Australia - UniSA Business School

Maurice Peat

The University of Sydney; Financial Research Network (FIRN)

Stephen Satchell

The University of Sydney

Date Written: August 15, 2015

Abstract

This paper considers liquidity as an explanation for the positive association between expected idiosyncratic volatility (IV) and expected stock returns. Liquidity costs may affect the stock returns, through bid-ask bounce and other microstructure-induced noise, which will affect the estimation of IV. We use a novel method (developed by Weaver, 1991) to eliminate microstructure influences from stock closing price-based returns and then estimate IV. We show that there is a premium for IV in value-weighted portfolios, but this premium is less strong after correcting returns for microstructure bias. We further show that this premium is driven by liquidity in the prior month after correcting returns for microstructure noise. The pricing results from equally-weighted portfolios indicate that IV does not predict returns either before or after controlling for liquidity costs. These findings are robust after controlling for common risk factors as well as analysing double-sorted portfolios based on IV and liquidity.

Keywords: liquidity, asset pricing, idiosyncratic volatility, expected returns

JEL Classification: G120

Suggested Citation

Bradrania, Reza and Peat, Maurice and Satchell, Stephen, Liquidity Costs, Idiosyncratic Volatility and Expected Stock Returns (August 15, 2015). International Review of Financial Analysis, Vol. 42, 2015, Available at SSRN: https://ssrn.com/abstract=3943312

Reza Bradrania (Contact Author)

University of South Australia - UniSA Business School ( email )

Adelaide, South Australia 5001
Australia

Maurice Peat

The University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Stephen Satchell

The University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

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