Arbitrage Asymmetry and the Idiosyncratic Volatility Puzzle

Abstract

Buying is easier than shorting for many equity investors. Combining this arbitrage asymmetry with the arbitrage risk represented by idiosyncratic volatility (IVOL) explains the negative relation between IVOL and average return. The IVOL-return relation is negative among overpriced stocks but positive among underpriced stocks, with mispricing determined by combining 11 return anomalies. Consistent with arbitrage asymmetry, the negative relation among overpriced stocks is stronger, especially for stocks less easily shorted, so the overall IVOL-return relation is negative. Further supporting our explanation, high investor sentiment weakens the positive relation among underpriced stocks and, especially, strengthens the negative relation among overpriced stocks. Disciplines Finance and Financial Management

Short‐Selling Risk

“…If all of these are missing, we calculate shareholder equity as total assets minus total liabilities. Finally, we add NYSE breakpoints and Fama and French (2015) factors from Kenneth French's Web site, and we add the Stambaugh, Yu, and Yuan (2015) mispricing score from Robert Stambaugh's Web site. Panel C of Table I presents summary statistics for the CRSP data.…”

“…The results are qualitatively unchanged if we instead use Newey and West (1987) standard errors with three lags, where we set the lag length = T ¼ = 66 ¼ 3 as discussed in Greene (2002). 16 Stambaugh, Yu, and Yuan (2015) do not use any short selling-based anomalies in their mispricing measure. 17 When there is no interaction term, the coefficient estimate on MISP is negative and significant as in Stambaugh, Yu, and Yuan (2015).…”

Idiosyncratic Volatility and Firm‐Specific News: Beyond Limited Arbitrage

“…Similarly, Ang et al (2009, p.12, table 6) find that the return on zero-cost portfolios using all non-US stocks has a three-factor alpha of -67 bp, of which -63 bp come from high-volatility stocks. More recently, Stambaugh et al (2015Stambaugh et al ( , p.1916 determine that the portfolio earns a three-factor alpha of -78 bp of which -69 bp are from the high-volatility portfolio and +8 bp are from the low-volatility portfolio. This evidence is consistent with the limited arbitrage explanation.…”

“…If volatility is merely a measure of disagreement, then low volatility implies that investors agree about the price of the stock and market imperfections cannot cause mispricing. Most notably and directly, Stambaugh et al (2015) construct an overvaluation index and analyze the pricing of volatility by level of overvaluation. They find that the price of idiosyncratic volatility is strong with 20% of the stocks that are in the highest overvaluation group.…”

“…1 While idiosyncratic volatility is typically assumed to capture firm-specific news announcements, little effort has been spent relating the pricing of idiosyncratic volatility to actual firm-specific news announcements. 2 This omission is particularly stark since one of the most promising explanations for the negative price relation, the limited arbitrage explanation from Stambaugh, Yu, and Yuan (2015), has an important role for firmspecific news. 3 Since volatility limits demand from arbitrageurs (Barberis and Thaler, 2003;Pontiff, 2006), stocks with high idiosyncratic volatility are potentially mispriced and the relation between…”