Liquidity Costs, Idiosyncratic Volatility and Expected Stock Returns

TL;DR

This study investigates how liquidity costs influence the relationship between idiosyncratic volatility and stock returns, revealing that liquidity plays a significant role in the IV premium, especially in value-weighted portfolios.

Contribution

It introduces a novel microstructure bias correction method to better estimate IV and demonstrates liquidity's impact on the IV-return relationship using multiple portfolio analyses.

Findings

IV premium exists in value-weighted portfolios but weakens after bias correction

Liquidity influences the IV premium, especially in the prior month

IV does not predict returns in equally-weighted portfolios after adjustments

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.