Idiosyncratic Volatility Puzzle And Explanations Based On Heterogeneous Beliefs: Evidence From China Stock Markets

Idiosyncratic volatility is the measure of firm-specific risk. The standard asset pricing theory assumes that the capital market is perfect and predicts that only systematic risks should be priced into the expected returns of assets. Investors can hold diversified portfolios to avoid firm-specific risk. However, predicted by a simple model of capital market equilibrium with incomplete information of Merton (1987), many investors can hardly construct a perfectly diversified market portfolio because of the constraint of transaction costs and incomplete information. So firms with larger firm-specific risk require higher average expected returns to compensate these investors for holding imperfectly diversified portfolios and there should be a positive relation between idiosyncratic volatility and expected returns. But much of the existing empirical evidence finds a strongly statistically significant negative relation between the idiosyncratic risk of individual stocks and the cross-section of expected returns. This phenomenon can not be well explained by the standard asset pricing theory and the model of capital market equilibrium with incomplete information of Merton (1987) and so it is regarded as "the idiosyncratic volatility puzzle". Using the Chinese stock markets data during the period of July 1997 to April 2007 and estimating idiosyncratic volatility as the standard deviation of residuals from the Fama-French (1993) three factor regression, I find a strongly statistically significant negative relationship between idiosyncratic volatility and the cross-section of expected returns. This phenomenon still holds after controlling for other risk factors such as size, book to market ratio and momentum etc. Estimating expected idiosyncratic volatility with auto regress model, I also find a significant negative relationship and it still holds after controlling for other risk factors such as size, book to market ratio and momentum etc. We can conclude that there exists the idiosyncratic volatility puzzle in Chinese stock markets as well. Finally I suggest that heterogeneous beliefs among investors may be an important factor to explain the idiosyncratic volatility puzzle.