The Idiosyncratic Volatility Anomaly Essay Example | Topics and Well Written Essays - 1500 words

The Idiosyncratic Volatility Anomaly - Essay Example Investors look to these corporate-level indicators when determining the most viable security purchase that will facilitate effective returns and minimize risk of volatility. The IVOL comes into play when a specific security does not conform to known economic models that illustrate either inverse relationships to tangible corporate level characteristics or direct relationships to known securities in a comparable category. Various factor-model equations have been developed to establish the expected rate of return of a security, utilising complex variables such as known excess stock returns, known sensitivities to volatility risk, and certain conditional market means (averages). Consider the complexity of one such factor-model calculation to determine expected security return: Exhibit 1: Factor-Model Calculation to Determine Expected Aggregate Returns Source: Ang, et al. (2006). The cross-section of volatility and expected returns. The interchangeable variables within similar equation m odelling dictate no elongated explanation of the complexity of this scientific approach to aggregate security returns. However, such models that determine not only future stock returns, but also volatility risk with a specific security or basket of securities in comparable industries, are designed to facilitate more effective and profitable security investment. The idiosyncratic volatility anomaly is an acknowledgement that not all common stock securities will produce returns that follow a logical model of analysis and computation based on known historical patterns of return and volatility. Various models for determining aggregate returns, based on corporate-level dynamics or market risks (among other criteria), should produce consistent stock returns that are in-line with mathematical expectations. The tangible market returns of a security will, at times, illustrate a direct relationship with such modelling that serves to justify these scientific methods of analyses. During other m arket conditions, such returns conflict these models designed to facilitate a more shrewd investment with no legitimate explanation as to why low returns occurred with the security. These are the dynamics of the idiosyncratic volatility anomaly: predictable corporate level characteristics and valuations of a firm, the known statistical significance of the model used to identify expected aggregate returns, and linear examination of historical stock trends should all serve to justify the long-term return of a security. What actually occurs in the stock market is a confliction of these predictive models, often with no concrete explanation for why the security became exposed to higher volatility, price shock, or variable returns. The IVOL is highly pervasive in domestic and global stock markets with many researchers seeking solutions for the recurring prevalence of this anomaly in the United States, the United Kingdom, and Eurasian nations (Chen, et al. 2012; Savickas and Zhao, 2012; Be rrada and Hugonnier, 2009; Jiang, et al. 2007). Berrada and Hugonnier (2009) identify this routine irregularity citing disparities between the idiosyncratic volatility factor with a direct relationship to stock returns in the U.S., and Ang, et.al (2006) confirming this factor tends to hold true in other nations. The dynamics of what genuinely causes the IVOL prevalence is uncertain, as no singular method of determining its catalysts has yet been determined. However, there is speculation that it can be related to