Idiosyncratic volatility refers to the unpredictable or unique fluctuations in a particular entity's value, such as a company's stock, that cannot be explained by the overall market movements. It represents the degree to which the performance or volatility of an individual asset diverges from the average market or industry behavior.
Full definition
The association
between idiosyncratic volatility and worsening earnings quality is more pronounced when the deterioration in earnings quality is related to managerial discretion.
They
identify idiosyncratic volatility shocks as large deviations from the volatility predicted out - of - sample by a regression model that accounts for market, size and book - to - market effects.
In their May 2006 paper entitled «The Relation between Time - Series and Cross-Sectional Effects of Idiosyncratic Variance on Stock Returns in G7 Countries», Hui Guo and Robert Savickas investigate why the
realized idiosyncratic volatility (beta) of individual stocks correlates negatively with future returns — why there is a penalty instead of a reward for this apparent risk.
In their August 2016 paper entitled «Unusual News Flow and the Cross-Section of Stock Returns», Turan Bali, Andriy Bodnaruk, Anna Scherbina and Yi Tang investigate relationships among sudden increases in
stock idiosyncratic volatility, unusual firm news, changes in analyst earnings forecast dispersion, short selling and future returns.
In contrast, larger - capitalization stocks with substantial tangible assets, high liquidity and
low idiosyncratic volatility are less susceptible to sentiment - related mispricing.
They examine three measures of return comovement for each asset class: average pairwise correlation, average beta relative to the world market and
average idiosyncratic volatility.
His analysis focuses on 14 anomalies arguably tied to investor sentiment, with one side (short or long) speculative and the other side non-speculative, based
on idiosyncratic volatility, lottery - like, firm age, distress, profitability, payouts, size or illiquidity.
Investors chasing hot stocks, or uncertain earnings, create
high idiosyncratic volatility that reverses to correct for over-pricing, or when uncertainty gets resolved.
She
defines idiosyncratic volatility as the standard deviation of daily residuals from monthly regressions of returns (in excess of the risk - free rate) for each stock versus Fama - French model factors.
They seem to agree with Greenblatt when they find that the higher alpha of the equal - weighted portfolio arises from the monthly rebalancing required to maintain equal weights, which is a «contrarian strategy that exploits reversal and
idiosyncratic volatility of the stock returns; thus, alpha depends only on the monthly rebalancing and not on the choice of initial weights.»
MiFID II is expected to result in less sell - side research coverage of companies, which potentially increases pricing inefficiencies and
idiosyncratic volatility, as information may not spread through the markets.
In her April 2013 paper entitled «Revisiting
Idiosyncratic Volatility and Stock Returns», Fatma Sonmez re-examines the relationship between idiosyncratic volatility and future stock returns.
For me, the most important part of the study is the finding that «The nonparametric monotonicity relation test indicates that the differences in the total return of the equal - weighted portfolio and the value - and price - weighted portfolios is monotonically related to size, price, liquidity and
idiosyncratic volatility.»