Working Paper: NBER ID: w18560
Authors: Robert F. Stambaugh; Jianfeng Yu; Yu Yuan
Abstract: Short selling, as compared to purchasing, faces greater risks and other potential impediments. This arbitrage asymmetry explains the negative relation between idiosyncratic volatility (IVOL) and average return. The IVOL effect is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. The negative effect is stronger, consistent with asymmetry in risks and other impediments inhibiting arbitrageurs in exploiting overpricing. Aggregating across all stocks therefore yields a negative relation, explaining the IVOL puzzle. Further supporting our explanation is a negative relation over time between the IVOL effect and investor sentiment, especially among overpriced stocks.
Keywords: idiosyncratic volatility; arbitrage; mispricing; investor sentiment
JEL Codes: G02; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher idiosyncratic volatility (ivol) (G19) | greater arbitrage risk (F31) |
| greater arbitrage risk (F31) | negative impact on expected returns among overpriced stocks (G41) |
| higher idiosyncratic volatility (ivol) (G19) | higher mispricing among overpriced stocks (G41) |
| higher mispricing among overpriced stocks (G41) | negative ivol effect on expected returns (G40) |
| higher idiosyncratic volatility (ivol) (G19) | positive ivol effect among underpriced stocks (G14) |
| negative ivol effect among overpriced stocks (G41) | stronger than positive ivol effect among underpriced stocks (G41) |
| high investor sentiment (G41) | exacerbates negative ivol effect among overpriced stocks (G41) |