## Abstract

Abstract

Purpose – This study aims to examine what underlies the estimated relation between idiosyncratic volatility

and realized return.

Design/methodology/approach – Idiosyncratic volatility has a dual effect on stock pricing: it not only

affects investors’ expected return but also affects the efficiency of stock price in reflecting its value. Therefore,

the estimated relation between idiosyncratic volatility and realized return captures its relations with both

expected return and the mispricing-related component due to its dual effect on stock pricing. The sign of its

relation with the mispricing-related component is indeterminate.

Findings – The estimated relation between idiosyncratic volatility and realized return decreases and switches

from positive to negative as the estimation sample consists of proportionately more ex ante overvalued

observations; it increases and switches from negative to positive as the estimation sample consists of

proportionately more ex post overvalued observations. In sum, the relation of idiosyncratic volatility with the

mispricing-related component dominates its relation with expected return in its estimated relation with realized

return. Moreover, its estimated relation with realized return varies with research design choices and even

switches sign due to their effects on its relation with the mispricing-related component.

Originality/value – The novelty of the study is evident in the implication of its findings that one cannot infer

the sign of the relation of idiosyncratic volatility with expected return from its estimated relation with realized

return.

Purpose – This study aims to examine what underlies the estimated relation between idiosyncratic volatility

and realized return.

Design/methodology/approach – Idiosyncratic volatility has a dual effect on stock pricing: it not only

affects investors’ expected return but also affects the efficiency of stock price in reflecting its value. Therefore,

the estimated relation between idiosyncratic volatility and realized return captures its relations with both

expected return and the mispricing-related component due to its dual effect on stock pricing. The sign of its

relation with the mispricing-related component is indeterminate.

Findings – The estimated relation between idiosyncratic volatility and realized return decreases and switches

from positive to negative as the estimation sample consists of proportionately more ex ante overvalued

observations; it increases and switches from negative to positive as the estimation sample consists of

proportionately more ex post overvalued observations. In sum, the relation of idiosyncratic volatility with the

mispricing-related component dominates its relation with expected return in its estimated relation with realized

return. Moreover, its estimated relation with realized return varies with research design choices and even

switches sign due to their effects on its relation with the mispricing-related component.

Originality/value – The novelty of the study is evident in the implication of its findings that one cannot infer

the sign of the relation of idiosyncratic volatility with expected return from its estimated relation with realized

return.

Original language | English |
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Pages (from-to) | 226-259 |

Journal | China accounting and finance review (中國會計與財務硏究) |

Volume | 24 |

Issue number | 2 |

Publication status | Published - May 2022 |