Explaining Idiosyncratic Volatility Puzzle and Lottery-Like Stock with Extreme Returns: Evidence from Emerging Stock Market

Abstract

This paper explores the possibility that idiosyncratic volatility may cause unexpectedly high levels of volatility in the Pakistani stock market. This study further analyzes the Pakistani stock market as there has been much discussion about the existence of a pervasive idiosyncratic volatility puzzle since the market as a whole low volatility stock has significantly grown. The study implemented the Fama-French six-factor model to the data of common stocks traded on the Pakistan Stock Exchange between the time period of 2003 to 2020 in order to quantify idiosyncratic volatility. The expected return is then investigated as a possible explanation for the anomalous volatility. The authors discover that individual stock price swings are strongly linked to predicted returns. As the company-level factors have a strong explanatory power when it comes to explaining idiosyncratic volatility for equity returns, based on the findings of this study, we can conclude that the expected returns for firms with strong idiosyncratic volatility are extraordinarily high, and this problem disappears once firm-level factors are taken into account. Additionally, it is found that stocks with high skewness and high idiosyncratic volatility have underperformed the market over almost two decades.  Overall, our results imply that the mystery emerges because highly volatile equities are overvalued and then undergo a subsequent correction because of their high max effect/lottery properties. Investment lottery preferences and market frictions have been cited in the literature as possible causes of idiosyncratic volatility. An expected return measure for stocks as a proxy for the over-valuation of stock returns and discover the relevance of idiosyncratic volatility in solving the idiosyncratic volatility puzzle.