Liquidity costs, idiosyncratic volatility and expected stock returns

Reza Bradrania, Maurice Peat and Stephen Satchell

International Review of Financial Analysis, 2015, vol. 42, issue C, 394-406

Abstract: This paper considers liquidity as an explanation for the positive association between expected idiosyncratic volatility (IV) and expected stock returns. Liquidity costs may affect the stock returns, through bid-ask bounce and other microstructure-induced noise, which will affect the estimation of IV. We use a novel method (developed by Weaver, 1991) to eliminate microstructure influences from stock closing price-based returns and then estimate IV. We show that there is a premium for IV in value-weighted portfolios, but this premium is less strong after correcting returns for microstructure bias. We further show that this premium is driven by liquidity in the prior month after correcting returns for microstructure noise. The pricing results from equally-weighted portfolios indicate that IV does not predict returns either before or after controlling for liquidity costs. These findings are robust after controlling for common risk factors as well as analysing double-sorted portfolios based on IV and liquidity.

Keywords: Liquidity; Asset pricing; Idiosyncratic volatility; Expected returns (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S1057521915001520
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:finana:v:42:y:2015:i:c:p:394-406

DOI: 10.1016/j.irfa.2015.09.005

Access Statistics for this article

International Review of Financial Analysis is currently edited by B.M. Lucey

More articles in International Review of Financial Analysis from Elsevier
Bibliographic data for series maintained by Catherine Liu ().