LAGGED IDIOSYNCRATIC RISK AND ABNORMAL RETURN

According to financial theory, idiosyncratic risk is eliminated within a diversified portfolio andtherefore should not be related to expected return. However, in the last decade financial economistshave started to debate and provide evidence that showed that either idiosyncratic risk is positivelyor negatively related to future abnormal return.Our paper follows these recent studies and examines the relationship between idiosyncraticvolatility and abnormal return in the following year. Hence, our measure of idiosyncratic volatilityis an annual measure, and we use it to predict the abnormal return in the following year. We dividecompanies into five tranches of idiosyncratic volatility level each year, and then analyse andcompare their abnormal return in the following year.Our result suggests that stock returns are negatively related to the one-year lagged idiosyncraticvolatilities. Most important, it seems that most of the explanatory power is derived from the highestidiosyncratic volatility level stocks as they yield the most negative abnormal returns in thefollowing year.