Idiosyncratic Volatility and Expected Returns at the Global Level

TLDR: In this paper, the authors investigate the existence and significance of a cross-sectional relation between idiosyncratic volatility and expected returns at the global level by introducing a global idiosyncratic measure and globally diversified test assets.

Abstract: We investigate the existence and significance of a cross-sectional relation between idiosyncratic volatility and expected returns at the global level by introducing a global idiosyncratic volatility measure and globally diversified test assets. We find that the portfolios with the highest and lowest global idiosyncratic volatility don’t earn significantly different average returns, indicating the absence of a link between global idiosyncratic volatility and expected returns. This result is robust to three different samples utilized; two different asset pricing models, two different data frequencies, and an alternative idiosyncratic volatility definition used to estimate global idiosyncratic volatility; two different weighting schemes to calculate portfolio returns and after controlling for the size of the global idiosyncratic volatility sorted portfolios. It also holds for four different sub-periods and eight subsamples reflecting different states of the economy and stock markets. Our results show that global diversification is effective in stabilizing the returns of global test assets as global investors don’t require a risk premium for bearing global idiosyncratic volatility and that benefits from global diversification can be gained by diversifying across countries or across industries.