Quality's relationship to the idiosyncratic volatility puzzle

Sammanfattning: This paper examines the well documented relationship between idiosyncratic volatility and mean returns. By using the recently published quality-minus-junk factor this paper attempts to explain both the abnormal performance of portfolios sorted on idiosyncratic volatility as well as the crosssectional pricing of idiosyncratic volatility. Using data from the U.S. it is shown that the quality factor is able to explain the abnormal performance of the extreme portfolios in the idiosyncratic volatility puzzle, while having no impact on the cross-sectional stock returns. This indicates that the quality-minus-junk factor plays an important role in determining the performance of the portfolios and further research should include it in any model aiming to investigate this puzzle.