Idiosyncratic Volatility Covariance and Expected Stock Returns

Authors

  • David R. Peterson,

    Search for more papers by this author
    • David R. Peterson is the Wells Fargo Professor of Finance in the College of Business at Florida State University in Tallahassee, Florida. Adam R. Smedema is an Assistant Professor in the Department of Finance, College of Business Administration at University of Northern Iowa in Cedar Falls, IA.

  • Adam R. Smedema

    Search for more papers by this author
    • David R. Peterson is the Wells Fargo Professor of Finance in the College of Business at Florida State University in Tallahassee, Florida. Adam R. Smedema is an Assistant Professor in the Department of Finance, College of Business Administration at University of Northern Iowa in Cedar Falls, IA.


  • We thank Marc Lipson (Editor) and two anonymous reviewers for helpful feedback and criticism. We also thank seminar participants at the University of Northern Iowa for helpful comments. Adam Smedema acknowledges that a portion of the research was done in fulfillment of requirements for his dissertation “Two Essays on Idiosyncratic Volatility” while at Florida State University. He thanks his dissertation committee for help with this research.

Abstract

Given that the idiosyncratic volatility (IDVOL) of individual stocks co-varies, we develop a model to determine how aggregate idiosyncratic volatility (AIV) may affect the volatility of a portfolio with a finite number of stocks. In portfolio and cross-sectional tests, we find that stocks whose returns are more correlated with AIV innovations have lower returns than those that are less correlated with AIV innovations. These results are robust to controlling for the stock's own IDVOL and market volatility. We conclude that risk-averse investors pay a premium for stocks that pay well when AIV is high, consistent with our model.

Ancillary