The Relation between Time-Series and Cross-Sectional Effects of Idiosyncratic Variance on Stock Returns in G7 Countries

摘要

Recent studies document a close link between a firm's idiosyncratic variance (IV) and its growth options. The valuation of growth options depends crucially on discount rates-a measure of investment opportunities in ICAPM; therefore,IV predicts stock returns possibly because it is a proxy for loadings on systematic risk omitted from CAPM. We test the idea using the G7 countries' data in three ways. First,loadings on stock market variance and average IV account for a large portion-e.g.,80% for the U.S. data over the 1927-2005 period-of variation in average returns on portfolios sorted by IV. Second,the return spread between low IV and high IV stocks performs just as well as the Fama and French (1993) B/M factor in explaining the cross-section of stock returns. Third,lagged returns on high IV stocks correlate negatively with future stock market returns,while the predictive power is negligible for low IV stocks.