Incomplete Information, Idiosyncratic Volatility and Stock Returns

Posted: 14 Jan 2009

See all articles by Julien Hugonnier

Julien Hugonnier

École Polytechnique Fédérale de Lausanne; Centre for Economic Policy Research (CEPR)

Tony Berrada

University of Geneva - Geneva Finance Research Institute (GFRI); Swiss Finance Institute

Multiple version iconThere are 3 versions of this paper

Date Written: January 9, 2009

Abstract

We develop a model of firm investment under incomplete information that explains why idiosyncratic volatility and stock returns are related. When the unobserved state variable proxies for the business cycles, we show that a properly calibrated version of the model generates a negative relation due to the natural asymmetry in the length of expansions and recessions. We further show that, conditional on earning surprises, the relation between idiosyncratic volatility and stock returns is positive after good news and negative after bad news. This result provides new insights on the nature of stock return predictability.

Keywords: idiosyncratic volatility, incomplete information, cross-section of returns, q-theory of investment

JEL Classification: G12, D83, D92

Suggested Citation

Hugonnier, Julien and Berrada, Tony, Incomplete Information, Idiosyncratic Volatility and Stock Returns (January 9, 2009). EFA 2009 Bergen Meetings Paper, Available at SSRN: https://ssrn.com/abstract=1326840

Julien Hugonnier

École Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL Dorigny
Extranef
Lausanne, CH-1015
Switzerland

HOME PAGE: http://https://www.epfl.ch/labs/sfi-jh/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Tony Berrada (Contact Author)

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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