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RFS Advance Access originally published online on April 11, 2008
Review of Financial Studies 2008 21(3):1259-1296; doi:10.1093/rfs/hhn043
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© The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org

Average Idiosyncratic Volatility in G7 Countries

Hui Guo
University of Cincinnati

Robert Savickas
George Washington University

Address correspondence to Hui Guo, Department of Finance, University of Cincinnati, P.O. Box 210195, Cincinnati, OH 45221-0195; E-mail: hui.guo{at}uc.edu

JEL Classification: G1


  Abstract

We argue that changes in average idiosyncratic volatility provide a proxy for changes in the investment opportunity set and that this proxy is closely related to the book-to-market factor. We test this idea in two ways using G7 countries’ data. First, we show that idiosyncratic volatility has statistically significant predictive power for aggregate stock market returns over time. Second, we show that idiosyncratic volatility performs just as well as the book-to-market factor in explaining the cross section of stock returns. Our results suggest that the hedge against changes in investment opportunities is an important determinant of asset prices.

We are especially grateful to an anonymous referee and the editor, Joel Hasbrouck, for numerous insightful and constructive comments, which greatly improved the paper. We thank Andrew Ang, Torben Andersen, Samuel Thompson, Tuomo Vuolteenaho, Mathijs van Dijk, Valerio Poti, and participants at the 2005 Financial Management Association meeting in Chicago, the 2005 Southern Finance Association meeting in Key West, the 2006 Washington Area Finance Association meeting in Washington DC, the 2006 Financial Management Association European meeting in Stockholm, and the 2006 INFINITI Conference in Dublin for helpful suggestions and discussion. We also thank Timothy Vogelsang for providing Gauss codes and Jason Higbee for excellent research assistance.


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