This article re-examines the relationship between idiosyncratic volatility and the cross-section of stock returns. Previous studies, using total realized returns as proxies for expected returns,have found ambiguous and conflicting relationships between expected idiosyncratic volatility and expected returns. We decompose idiosyncratic volatility into expected and unexpected idiosyncratic volatility, and use unexpected idiosyncratic volatility to control for unexpected returns so that the relationship between expected returns and expected idiosyncratic volatility can be observed with more clarity. We find expected idiosyncratic volatility to be significantly and positively related to expected returns. In addition, we find evidence suggesting that unexpected idiosyncratic volatility is positively related to unexpected returns and that this relationship is consistent with the option effect proposed by Merton (1974).
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