The dual effect of idiosyncratic volatility on stock pricing and return

Abstract

This study aims to examine what underlies the estimated relation between idiosyncratic volatility and realized return. Idiosyncratic volatility has a dual effect on stock pricing: it not only affects investors' expected return but also affects the efficiency of stock price in reflecting its value. Therefore, the estimated relation between idiosyncratic volatility and realized return captures its relations with both expected return and the mispricing-related component due to its dual effect on stock pricing. The sign of its relation with the mispricing-related component is indeterminate. The estimated relation between idiosyncratic volatility and realized return decreases and switches from positive to negative as the estimation sample consists of proportionately more ex ante overvalued observations; it increases and switches from negative to positive as the estimation sample consists of proportionately more ex post overvalued observations. In sum, the relation of idiosyncratic volatility with the mispricing-related component dominates its relation with expected return in its estimated relation with realized return. Moreover, its estimated relation with realized return varies with research design choices and even switches sign due to their effects on its relation with the mispricing-related component. The novelty of the study is evident in the implication of its findings that one cannot infer the sign of the relation of idiosyncratic volatility with expected return from its estimated relation with realized return.

Keywords

• idiosyncratic volatility
• stock pricing efficiency
• realized return
• expected return
• asset pricing puzzle