Idiosyncratic Volatility, Momentum, Liquidity, and Expected Stock Returns in Developed and Emerging Markets

Abstract

This paper re-examines the link between idiosyncratic risk and expected returns for a large sample of firms in both developed and emerging markets. Recent studies using Fama-French three-factor models have shown a negative relationship between idiosyncratic volatility and expected returns for developed markets. This relationship has not been studied to date for emerging markets. This study relates the current-month’s idiosyncratic volatility to the subsequent month’s stock returns for a sample of both developed and emerging markets expanding benchmark factors by including both a momentum and a systematic liquidity risk component. Using a five-factor model, the results suggest that idiosyncratic risk does not play a role on stock returns for most of the developed markets analyzed. In contrast, the paper shows, for the first time, that idiosyncratic risk is positively related to month-ahead expected returns for many emerging markets for this model.

Keywords: idiosyncratic volatility; expected returns; developed vs. emerging markets; asset pricing; multifactor models

JEL Classification: G11, G12, G15