Two essays on idiosyncratic stock return volatilities
Document TypePhD thesis
Access StatusOpen Access
© 2016 Dr Yichao Zhu
This thesis consists of two essays on idiosyncratic stock return volatilities (IVOL). In the first essay (Chapter 3), I find that the negative relation between IVOL and subsequent stock returns (the IVOL puzzle) does not depend on whether the stocks perform well or poorly in the formation month. I also find that this negative relation persists for a holding period of up to 12 months. Taken together, these two findings highlight that short-term return reversals can explain only part of the IVOL puzzle. I examine the missing factors proposed in the literature and find that the common IVOL factor can largely explain the persistence of the IVOL puzzle beyond the first holding month. I also investigate a possible explanation of the IVOL puzzle related to the convex return patterns induced by the real options among high-IVOL stocks. In the second essay (Chapter 4), we show that time-varying financial leverage generates a common factor structure in firm-level IVOL, with the presence of sticky debt in a model where asset returns follow a simple linear factor structure with constant volatility. Under reasonable parameter settings in a standard dynamic capital structure model, we numerically show that on average about 25% of the time variation in firm-level IVOL can be explained by a single factor. This proportion falls to zero when using a purely equity financed sample. We also show that exposure to the common IVOL factor is negatively priced, even though IVOL is positively priced in the cross-section.
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