Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle
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.
We are grateful for helpful comments from Lubos Pastor and seminar participants at the University of Minnesota, University of Oxford, University of Toronto, and the Shanghai Advanced Institute of Finance. We also thank Edmund Lee and Jianan Liu for excellent research assistance. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Robert F. Stambaugh & Jianfeng Yu & Yu Yuan, 2015. "Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle," Journal of Finance, American Finance Association, vol. 70(5), pages 1903-1948, October. citation courtesy of