Low-Risk Anomaly : Idiosyncratic Risk or Return Distribution

A large number of explanations of the low-risk anomaly have since been proposed, including leverage constraints, lottery preference, correction of market-driven overpricing, and so on. Based on data from the Chinese stock market, we conduct an examination of low-risk anomalies and investigate possible underlying causes. By dividing low-risk variables into systematic/idiosyncratic volatility and distribution-related variables, we find that the low-risk anomaly is concentrated among small firms and is driven mainly by stock’s idiosyncratic volatility (IV). Our findings encompass the following three aspects: (1) The pricing of beta/correlation can be explained by IV while controlling for distribution characteristics still leaves a significant correlation premium. (2) The pricing of distribution variables depends on low investor sentiment and the falling industries, and meanwhile, IV exhibits better performance in other circumstances. (3) Consistent with Lee and Swaminathan (2000), we suggest that trading volume may play a key role in this phenomenon. IV is less affected by trading volume while among extreme winner and loser portfolios, trading volume can earn substantial returns, which decreases the strength of return reversal. Our results indicate that, in the Chinese market, not leverage constraints but lottery preferences and correction of market-driven overpricing contribute to this anomaly