Incomplete information, idiosyncratic volatility and stock returns

We develop a q-theoretic model of investment under incomplete information that explains the link between idiosyncratic volatility and stock returns. When calibrated to match properties of the US business cycles as well as various firms and industry characteristics, the model generates a negative relation between idiosyncratic volatility and stock returns. We show that conditional on earning surprises, the link is positive after good news and negative after bad news. This result provides new insights on the nature of stock return predictability.