Incomplete information, idiosyncratic volatility andstock returns

This paper proposes and tests a model of firm valuation under incompleteinformation that explains the ambiguous relation between idiosyncratic volatilityand stock returns. Specifically, we show that, when investors have incompleteinformation, expected returns as measured by an econometrician deviate from theCAPM by including a term that is the product of the stock’s idiosyncratic volatilityand the investors’ aggregated forecast errors. If investors are biased then this termis on average non zero and generates a theoretical relation between idiosyncraticvolatility and expected stocks returns...