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Liquidity costs, idiosyncratic volatility and expected stock returns

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  • Reza Bradrania, M.
  • Peat, Maurice
  • Satchell, Stephen

Abstract

This paper considers liquidity as an explanation for the positive association between expected idiosyncratic volatility (IV) and expected stock returns. Liquidity costs may affect the stock returns, through bid-ask bounce and other microstructure-induced noise, which will affect the estimation of IV. We use a novel method (developed by Weaver, 1991) to eliminate microstructure influences from stock closing price-based returns and then estimate IV. We show that there is a premium for IV in value-weighted portfolios, but this premium is less strong after correcting returns for microstructure bias. We further show that this premium is driven by liquidity in the prior month after correcting returns for microstructure noise. The pricing results from equally-weighted portfolios indicate that IV does not predict returns either before or after controlling for liquidity costs. These findings are robust after controlling for common risk factors as well as analysing double-sorted portfolios based on IV and liquidity.

Suggested Citation

  • Reza Bradrania, M. & Peat, Maurice & Satchell, Stephen, 2015. "Liquidity costs, idiosyncratic volatility and expected stock returns," International Review of Financial Analysis, Elsevier, vol. 42(C), pages 394-406.
    • Handle: RePEc:eee:finana:v:42:y:2015:i:c:p:394-406
    DOI: 10.1016/j.irfa.2015.09.005
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    More about this item

    Keywords

    Liquidity; Asset pricing; Idiosyncratic volatility; Expected returns;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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