Idiosyncratic Risk and Expected Stock Returns: An Empirical Investigation on the GIPS Countries

Sammanfattning: The thesis aims to provide a framework for understanding how the idiosyncratic risk (IVOL) may affect the returns of individual stocks in the context of the Capital Asset Pricing Model and the Fama-French three factor model. We examine the Greek, Italian, Portuguese and Spanish (GIPS) Equity Markets. The final sample includes 654 stocks over the years 1992-2012. Classical financial theory argues that IVOL has no role in explaining why some securities may have higher returns than others, while alternative theories of behavioral finance predict a positive relationship between idiosyncratic risk and excess stock returns. Recent empirical findings developed by Ang, et al. (2006) indicate a negative relationship (IVOL puzzle). The purpose of this paper is to verify whether the pricing models tested in the U.S. market can find confirmation in the GIPS stock markets. In other words, we would like to test whether the IVOL puzzle should be accepted or rejected in the context of the four countries considered. We demonstrate that a zero-cost investment strategy long in securities with lower IVOL and short in securities with higher IVOL earns an economically positive and statistically significant alpha versus both the CAPM model (1.32%) and the FF-3 one (1.18%), suggesting a negative return towards holding idiosyncratic volatility. In line with the previous studies conducted on IVOL, our findings indicate that the low IVOL strategy is positively related to the value premium. In conclusion, we find a positive relation between idiosyncratic risk and systematic risk (market beta).