Idiosyncratic Volatility And Subsequent Returns: The Association Between Temporary Changes In Idiosyncratic Volatility And Observed Returns
Speaker(s) Prof. Raman Kumar, Professor of Investment Management, Department of Finance, Pamplin College of Business, Virginia Tech
ABSTRACT

We document a systematic pattern of changes in both the estimated idiosyncratic volatility and realized stock returns during the period when stocks sorted on idiosyncratic volatility are grouped into portfolios. We further document that these related systematic changes in estimated idiosyncratic volatility and realized returns combined with the relationship between past and future observed returns creates a relationship between idiosyncratic volatility and subsequent period returns. After controlling for past returns, there is no significant relation between idiosyncratic volatility and subsequent period returns. Moreover, we find no significant relation between idiosyncratic volatility and subsequent returns for subsets of stocks that do not exhibit any significant changes in idiosyncratic volatility despite large differences in the levels of their idiosyncratic volatility. Results suggest that the previously documented IVOL puzzle is primarily driven by recent negative and volatile returns and the associated short-term temporary changes in IVOL. Results also show that the changes in IVOL, both positive and negative, are associated with subsequent lower returns, with a stronger association between positive changes in IVOL and subsequent lower returns.


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