Impact Trend and Determinants of Idiosyncratic Volatility Affecting Stock Returns An Empirical Study on Indian Market

Abstract

newline Idiosyncratic volatility (IVOL) is the firm-specific risk related to the business of a firm that can be eliminated with diversification and hence, known as diversifiable risk. The traditional asset pricing model (CAPM) (proposed by Sharpe, 1964; Lintner, 1965; Black, 1976) argues that only market risk should be able to predict cross-sectional stock returns in the equilibrium. The argument of CAPM holds under the assumptions that the market is efficient, all investors are rational and they hold a perfectly diversified portfolio i.e., a combination of market-portfolio and risk-free assets. Thus, the role of idiosyncratic volatility explaining the variation in cross-sectional returns is completely excluded since the effect of idiosyncratic volatility is diversifiable, and investors are compensated for the non-diversifiable (market) risk taken in the stock investment. Over the years, the basic CAPM model has undergone several changes and got updated with efficient multifactor models (i.e., Fama-French three-factor model proposed by Fama and French, 1993 and Carhart s 1997 four-factor model). These factor models have also ignored the potential returns predicting power of idiosyncratic volatility. In contrast to the notion of perfect diversification by investors, Merton (Merton, 1987) acknowledges the presence of information asymmetry in the market which deters investors to achieve perfect diversification making them vulnerable to the idiosyncratic volatility of a firm. Merton argues that as these under-diversified investors are exposed to idiosyncratic volatility, they should be compensated for bearing the idiosyncratic volatility, indicating a positive relationship between idiosyncratic volatility and cross-sectional returns. With this theoretical background, we turn our attention to the empirical evidence present in the literature documenting the relationship between idiosyncratic volatility and cross-sectional stock returns. Interestingly, the empirical evidence on the impact of IVOL is contradictory.