Unique Volatility And Average Gains

Investors care about not only the expected return but also the risk that should be taken when making their investment decisions. Classical asset pricing models assume that only systematic risk matters, while idiosyncratic risk does not. But the real capital market is not that perfect like described in the theory, the incompleteness in the market and the information heterogeneity between investors may cause the idiosyncratic risk to matter as well. Individual investors dominate the A-share market for a long time since the setup of the market. These investors usually hold under-diversified portfolio. It indicates that idiosyncratic risk will matter and the study on idiosyncratic risk and stock return deserves.This thesis focuses on the relation between idiosyncratic volatility (IV) and stock return in the A-share market. We estimate the idiosyncratic volatility using the daily data within a specified month by Fama-French 3-factor model. We find that the negative correlation between IV and future monthly return is robust whether we use the cross-sectional Fama-MacBeth method or the factor mimicking method. In addition, the correlation cannot be explained by the size effects, value effects, liquidity effects, and return reversal characteristics. Even when the asymmetry in the underlying distribution of stock return, caused by stock price jumps, is considered, we find no significant changes in the abnormal return.The information types matter in the correlation between IV and stock return. Using the current return proxy for the information type, we find that when positive information comes, the correlation is much stronger than when the negative one comes. Besides that, we find no evidence showing that institutional investor participation will have a significant effect on the correlation.We also analyze the role played by macroeconomic condition. Using the state-space model, we filter out the expected industry output growth, the expected monetary supply M1 growth, and the expected inflation rate. We show that IV is significantly correlated with the expected output growth and the expected inflation rate and that the above three variables can significantly explain the dynamics of the abnormal return caused by IV. To some extent, we provide some perspectives on the correlation between idiosyncratic volatility and future stock return.