Abstract
In my dissertation, I investigate the pricing of idiosyncratic volatility in asset returns. Traditional models of asset returns assume that investors hold large, well-diversified portfolios. As such, only systematic risks should matter in the pricing of returns. Recent empirical research has shown that idiosyncratic volatility, in fact, does matter for asset returns. In my first essay, I focus on reviewing the existing evidence and investigate possible drivers of the known relation between returns and idiosyncratic volatility. I show that the negative relation between realized idiosyncratic volatility, measured over the prior month, and returns is robust in non-January months. Controlling for realized idiosyncratic volatility, I show that the relation between returns and expected idiosyncratic volatility is positive and robust. Realized and expected idiosyncratic volatility are separate and important effects describing the cross-section of returns. I find the negative return on a zero-investment portfolio that is long high realized idiosyncratic volatility stocks and short low realized idiosyncratic volatility stocks is dependent on aggregate investor sentiment. In cross-sectional tests, I find the negative relation is weaker for stocks with a large analyst following and stronger for stocks with high dispersion of analyst forecasts. The positive relation between expected idiosyncratic volatility and returns is not due to mispricing. In my second essay, I develop a hypothesis to reconcile the systematic risk principle and empirical evidence of the importance of idiosyncratic volatility (IV) in asset prices. I hypothesize that the idiosyncratic volatility of individual assets follows a common factor, the “IV factor.” I construct a new variable, the “IV beta,” to capture the empirical implications of this common IV factor. I empirically confirm my hypothesis. Zero-investment portfolios that are long high IV beta stocks and short low IV betas stocks have abnormal returns of about -0.25% per month. These results are confirmed by cross-sectional regressions. Results are robust to the inclusion of individual stock IV, which is diminished in importance. I conclude that the common IV factor is a priced factor as investors pay a premium for stocks that payoff well when innovations in the factor deteriorate the investment set.
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