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Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility around the World

Published online by Cambridge University Press:  24 February 2016

Yufeng Han ,
Ting Hu  and
David A. Lesmond
Yufeng Han
Affiliation:
yufeng.han@ucdenver.edu, University of Colorado Denver, Business School, Denver, CO 80217
Ting Hu
Affiliation:
thu@whu.edu.cn, Wuhan University, School of Economics and Management, Wuhan, Hubei 430072, China
David A. Lesmond*
Affiliation:
dlesmond@tulane.edu, Tulane University, Freeman School of Business, New Orleans, LA 70118.
*
*Corresponding author: dlesmond@tulane.edu
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Abstract

This paper examines data from 45 world markets and shows that the previously documented relation between mean returns and idiosyncratic volatility arises because of biases in volatility estimates that we can attribute to the bid–ask bounce in trade prices. We show that no significant relation exists between mean returns and idiosyncratic volatility estimated from quote-midpoint returns. Further, there is no significant relation between mean returns and the portion of transaction-price-based idiosyncratic volatility that is orthogonal to bid–ask spreads. The pricing of idiosyncratic volatility is due to the negative pricing of the bid–ask spread.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 50 , Issue 6 , December 2015 , pp. 1269 - 1292
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

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