Impact of Idiosyncratic Volatility on Average Stock Returns: Evidence from Sri Lanka

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.