Liquidity Biases and the Pricing of Cross-Sectional Idiosyncratic Volatility

We examine the cross-sectional relation between idiosyncratic volatility and stock returns and propose that the joint effect of the percentage of zero returns, that affects the loading on the systematic risk factors, and the bid-ask spread, that inflates the variance of the returns, biases the estimate of idiosyncratic volatility and the resulting pricing ability of idiosyncratic volatility. We model the microstructure influence on returns and derive a closed-form solution for the bias in the estimated idiosyncratic volatility. Motivated by this theory, our empirical results show that controlling for the liquidity costs on the estimation of idiosyncratic volatility diminishes to insignificance the ability of idiosyncratic volatility estimates to predict future returns. We confirm our findings by examining external shocks to liquidity, due to reductions in the stated quotes after 1997 and the decimalization of quotes in 2001, and find a significant reduction in the pricing ability of idiosyncratic volatility. Finally, minimizing liquidity's influence on the estimated idiosyncratic volatility, by orthogonalizing the percentage of zero return and spread effects on the estimated idiosyncratic volatility, demonstrates that the resulting idiosyncratic volatility estimate has little pricing ability