Abstract:
The complete diversification of idiosyncratic volatility is questionable due to factors such
as market imperfections, investor irrationality and managerial decisions. Therefore, the
purpose of this study is to investigate the impact of idiosyncratic volatility on average stock
returns in the Sri Lankan context. Using the five-factor asset pricing model of Fama and
French (2015) along with Exponential Generalised Autoregressive Conditional
Heteroskedasticity (EGARCH) estimated idiosyncratic volatility of stocks of firms listed on
the Colombo Stock Exchange (CSE), except for firms in banks, finance and insurance sectors,
this study reveals a positive and statistically significant association between average stock
returns and idiosyncratic volatility for the sample period from September 2004 to March 2018.
The empirical findings on firm profitability and investment yield striking evidence on
idiosyncratic volatility of stocks from a frontier market perspective, while uncovering the
importance of further research on the investor behaviour on asset pricing decisions.
