Empirical literature does not indicate a consensus on the relationship between idiosyncratic volatility and asset returns. Moreover the role of cross sectional higher order moments in predicting market returns is relatively unexplored. We study these areas for BRIICKS economies (Brazil, Russia, India, Indonesia, China, South Korea, and South Africa) and construct cross sectional variance of stock returns (CSV) as an alternative measure of idiosyncratic volatility (as suggested by Garcia et al, 2011). This measure has the advantage of being easily calculated at any frequency. Further, it is not based on any model and is therefore free from parametric biases. Another advantage of this cross sectional measure is that it can be conveniently extended to higher order moments.
We find that the CSV measure is highly correlated with alternative measures constructed as variance of errors from the capital asset pricing model (CAPM) and the Fama French (FF) model. We check the role of CSV and higher order moments (cross sectional skewness (CSS) and cross sectional kurtosis (CSK)) in explaining market returns at monthly and daily frequency. We find that CSV has a significant positive relationship with market returns only in some sample countries. The relationship of CSS and CSK with future market returns is normally positive (CSK in India is an exception). Further, the results are stronger for the daily data compared to the monthly data, which is in line with Garcia et al (2011).
We also check if CSV, CSS, and CSK contain any information which can be used by investors for constructing portfolios. Results show that there is no consistent relationship between CSV sensitivity and portfolio returns. Similar results are reported for CSK sensitivity sorted portfolios. More consistent results are obtained for the CSS measure. High CSS sensitivity sorted portfolios outperform low sensitivity sorted portfolios in five out of seven countries. The absolute risk premium is also generally higher for CSS sensitivity sorted portfolios. Further, asset pricing models explain portfolio returns satisfactorily, with some exceptions. On a risk adjusted basis, among the sample countries, South Africa offers the most profitable trading strategy based on CSS sorted portfolios. The study provides important implications for investment managers as well as researchers.
References: Garcia, R., Garcia, D.M. and Martellini L. (2011). Idiosyncratic risk and the cross-section of stock returns. EDHEC Working Paper. Retrieved from: http://professoral.edhec.com/servlet/com.univ.collaboratif.utils.Lecture...
