Idiosyncratic volatility in the Australian equity market

This paper studies the idiosyncratic volatility (IV) puzzle in the Australian equity market. I document a negative relation between IV and future stock returns. More importantly, this is the first Australian study to investigate the role of the asset-pricing model used to estimate IV. While recent work advocates a five-factor model incorporating investment and profitability factors, the findings suggest that the IV puzzle is not an outcome of investment and profitability factors being omitted from the three-factor model used to estimate IV. The exploration of potential causes of the IV puzzle suggests that it is attributable to mispricing, since it concentrates amongst the most-overpriced stocks as given by an Australian mispricing index. Decomposing the source of mispricing, the IV puzzle is largely explained by investors' preference for lottery-like stocks.