Idiosyncratic volatility and return: A finite mixture approach

Abstract

Using finite mixture normal regressions, we find that the relation between idiosyncratic volatility (IVOL) and realized return is negative for one latent group and positive for the other latent group. The intercept is larger for the group with a positive relation than for the group with a negative relation; the negative relation concentrates in firms with large negative realized return in the bottom two quintiles and the positive relation concentrates in firms with large positive realized return in the top two quintiles; the likelihood of having a negative relation is positively related to price-to-value ratio estimates. Realized return has a prominent mispricing-correction component that is negative (positive) for overvalued (undervalued) firms and decreases (increases) with the degree of overvaluation (undervaluation) corrected. Overall, our findings are consistent with the positive relation between IVOL and mispricing. Our findings suggest that an overall negative relation between IVOL and realized return is driven by the negative relation between IVOL and the mispricing-correction component from overvalued firms. Rationally determined expected return cannot be negative. Evidently, an overall negative relation between IVOL and realized return does not contradict the prediction of rational asset pricing theories.