<< Go Back

N. Branger, H. Hulsbusch, T. F. Middelhoff, “Idiosyncratic Volatility, its Expected Variation, and the Cross-Section of Stock Returns”

N. Branger, H. Hulsbusch, T. F. Middelhoff, “Idiosyncratic Volatility, its Expected Variation, and the Cross-Section of Stock Returns”

This paper explains the negative relation between the realized idiosyncratic volatility (IVOL) and expected returns. Using implicit information from the cross-section of options we extract expectations about the volatility of idiosyncratic volatility (IVOLVOL) in an almost model-free fashion. We show that IVOL is mean-reverting and that IVOLVOL serves as proxy for the meanreversion speed. Running double sorts on both measures reveals no differences in returns or alpha if the mean-reversion is low. However, the negative relation is amplified if IVOL shows fast mean-reversion. Both findings go along with a positive compensation for idiosyncratic risk. While for low mean-reversion, IVOL levels are expected to change little, current high (low) IVOL is expected to decrease (increase) by a lager amount for high mean-reversion. Thus, investors demand lower (higher) returns for current high (low) IVOL levels if it mean-reverts quickly. All our findings are supported by option trading behavior and are robust to different measures of IVOL, various stock characteristics and other competing explanations for the negative IVOL-return relation.

Download