Incomplete Information, Idiosyncratic Volatility and Stock Returns

Abstract

When investors have incomplete information, expected returns, as measured by an econometrician, deviate from those predicted by standard asset pricing models by including a term that is the product of the stock's idiosyncratic volatility and the investors' aggregated forecast errors. If investors are biased this term generates a relation between idiosyncratic volatility and expected stocks returns. Relying on forecast revisions from IBES, we construct a new variable that proxies for this term and show that it explains a signicant part of the empirical relation between idiosyncratic volatility and stock returns.

Keywords: Idiosyncratic volatility, incomplete information, cross-section of stock returns.

JEL Classification: G12, D83, D92