Common Idiosyncratic Volatility And Its Explanation For Anomalies In China's Stock Market

Idiosyncratic volatility is a hot topic in academic area of both China and foreign countries.According to Sharpe(1964)or Lintner(1965)traditional finance theory,idiosyncratic risk cannot bring return for investors because idiosyncratic risk can be eliminated through diversification.Merton(1987)suggest that investors cannot fully diversify their portfolio because they can acquire only incomplete information;therefore,stocks with high idiosyncratic volatility should give investors more compensation and thus have high returns.However,Ang et al.(2006)find that the return of stocks decreases as the idiosyncratic volatility of stocks goes up,which is not consistent with the finance theories above.Therefore,this phenomenon is called"idiosyncratic volatility puzzle" in academic area.On the other hand,Herskovic et al.(2016)study idiosyncratic volatility from the view of the whole stock market.They find that changes in idiosyncratic volatility of different stocks are simultaneous,which is triggered by a risk factor,and this factor is priced in the cross-section of stocks.Herskovic et al.(2016)proposed "Common Idiosyncratic Volatility(or CIV for short)" to proxy for this factor and CIV is calculated as the average of idiosyncratic volatility of stocks in the stock market.Additionally,Guo and Savickas(2010)find that lagged average idiosyncratic volatility and lagged market volatility(or MV for short)can explain the return variation of portfolios sorted by idiosyncratic volatility to a large extent.Since domestic literature rarely study idiosyncratic volatility from this point of view,we refer to Herskovic et al.(2016)and Guo and Savickas(2010)to study the pricing ability of CIV in the stock market of China and try to explain the "idiosyncratic volatility puzzle" and other anomalies in China from the view of CIV.We conclude that CIV has pricing ability in the stock market of China.In addition,we confirm that the "idiosyncratic volatility puzzle" exists in the stock market of China.In other words,portfolios with higher idiosyncratic volatility have lower returns than portfolios with lower idiosyncratic volatility have.This result is consistent with the empirical results of Zuo,Zheng and Zhang(2011)and Liu,Xing and Zhang(2014).We find that stocks with high idiosyncratic volatility also have high CIV-beta,and this kind of stocks are good hedging instruments against CIV risk,proposed in Herskovic et al.(2016).Herskovic et al.(2016)explain that this kind of stocks are preferred by investors and thus have relatively high stock price and low future returns.Finally,we find that CIV can explain other anomalies in the stock market of China,such as the anomaly returns of Amihud illiquidity portfolios and turnover portfolios.We find that portfolios with high Amihud illiquidity measure proposed in Amihud(2002)also have high excess returns and that portfolios with low turnover have high excess returns.These two empirical results are in accordance with the results of Li and Wu(2003).We find that CIV have pricing ability for these two kinds of portfolios.We select the A shares and Second-board Market stocks from 1995 to 2019 as our sample,excluding ST and PT stocks.First,we find that the idiosyncratic volatility in the stock market of China also changes simultaneously,which is similar to the phenomenon in the stock market of America.Second,we find that CIV is closely related to the average volatility of total profit's growth rate and the volatility of salary index in the cross section.The correlation coefficient between CIV and average volatility of total profit's growth rate is 0.515 and the correlation coefficient between CIV and the volatility of salary index is 0.43.Third,the return difference between the highest CIV-beta group and the lowest CIV-beta group is-0.641%per month.Herskovic et al.(2016)explain that investors prefer high CIV-beta stocks because they provide higher return when CIV increases and work as a good hedge against CIV risk.The risk premium we estimate based on CIV-beta portfolios using Fama and MacBeth(1973)method is-0.3%per month.The stock market of China is an important emerging market in the world,and the it is important to study the risk-return relation in the stock market of China.However,the stock market of China has its unique features which are different from the stock market of America.Cheng,Guo and Shi(2018)propose that the 10%price limit in the stock market of China causes positive auto-correlation of daily stock returns and error in estimating volatility.Therefore,we cannot use the method of computing CIV in Herskovic et al.(2016)directly to estimate CIV in the stock market of China.We use the method in Merton(1980)and Cheng,Guo and Shi(2018)to calculate CIV,allowing for the positive auto-correlation of daily stock returns.In addition,we calculated monthly CIV based on China's three-factor model proposed in Liu,Stambaugh and Yuan(2019)and obtain similar findings.These are also innovation points in this dissertation.We provide new proof supporting that CIV is an important risk factor and explore it allowing for the unique features of the stock market of China,which also enriches research findings in this field in the academic world of China.