Idiosyncratic Volatility, its Expected Variation, and the Cross-Section of Stock Returns

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We offer a novel perspective on the negative relation between idiosyncratic volatility (IVOL) and expected returns. We show that the IVOL puzzle is largely driven by a mean-reversion behavior of the stocks' volatilities. In doing so, we make use of option implied information to extract the expected mean-reversion speed of IVOL in an almost model-free fashion. Together with the current level of IVOL this method allows us to identify stocks' expected IVOL innovations. Under the assumption of IVOL carrying a positive price of risk (Merton (1987)) we resolve the puzzle. In a horse race we show that the mean-reversion speed is superior to the most prominent competing explanations.
All our findings are robust to different measures of IVOL and various stock characteristics.

Author(s):

Nicole Branger    
Finance Center Muenster, University of Muenster
Germany

Hendrik Hülsbusch    
Finance Center Muenster, University of Muenster
Germany

Frederik Middelhoff    
Finance Center Muenster, University of Muenster
Germany