Idiosyncratic Volatility And Return Of Stock: Based On China’s Stock Market

Risk asset pricing is one of the key contents of financial theory. Most academics pay much attentions to stocks’ system risk for a long time, without concerning the influence of idiosyncratic risk on stock’s return. Traditional theory believes that non-system risk(idiosyncratic risk) could be hedged in stock, so stock will not price it. This prejudice makes nobody cares about the residual term in factor model. But in recently years, some research find that stock’s idiosyncratic risk could influence its return. Based on the present research, this paper focus on China’s stock market, systematic investigate whether there is a significant relation between stocks’ idiosyncratic risk and return, whether factor model could completely explain the return of risk asset in such an emerging market.The research uses factor model based on panel data from all share A listed companies in China from the year 1991 to 2010, and defines idiosyncratic volatility as the standard deviation of residual of Fama-French 3-Factor model.In the first part, we investigate the group return in different measures of volatility risk. Specifically, we group data by standard deviation of stock’s return, system risk calculated by CAPM model and idiosyncratic volatility in turn, then do a mean test for every group’s return. In the second part, we group the data in two-dimension method and test the return of each group, to clarify the relation between idiosyncratic volatility and cross-section return. In this part, major considerations are stock’s value, book-to-market ratio, turnover ratio and momentum. In the third part, we do a two-stage cross-sectional test using Fama-Macbeth model. By virtue of this test, we investigate whether idiosyncratic volatility was priced by market, and whether idiosyncratic volatility caused s significant risk premium.In summary, we find that:(1) The mystery of “Idiosyncratic volatility” significantly exits in China capital market;(2) Corporations with a lower idiosyncratic volatility perform significantly higher return than corporations with a high idiosyncratic volatility; the accumulative return of different risk portfolio with different idiosyncratic volatility show an expanded trend along with the prolong of investment period;(3) Fama-Macbeth model test shows that idiosyncratic volatility has a significantly negative effort on stock return, which is contradictory with traditional finical theory.And, when grouping our stocks by stock value(book-to-market ratio) and idiosyncratic volatility, we find that in small size(low BM ratio) companies, different portfolios’ return are all descend when idiosyncratic volatility increasing. This means we could build such a trading strategy to get abnormal returns: buy in some small size, low idiosyncratic volatility stock portfolio, and sell out some large size, high idiosyncratic volatility stock portfolio. In this paper, this strategy could get a high return as much as 2.9% without more risk. This result increases our findings’ practical implications for real market trading.