What Drives the Trend and Behavior in Aggregate (Idiosyncratic) Variance? Follow the Bid-Ask Bounce

A number of competing explanations have been offered as a rationale for the trend in idiosyncratic variance that has been experienced over the past four decades. We establish a theoretical model linking a market microstructure bias with the industry-adjusted idiosyncratic variance (Campbell, Lettau, Malkiel, and Xu, 2001) or the risk-adjusted idiosyncratic variance. Using this model's predictions, we empirically show that the bid-ask spread eliminates the time trend in aggregate idiosyncratic variance. These results are robust across various exchanges, across various risk-based measures of idiosyncratic variance, and through time. Two natural experiments demonstrate that an exogenous shock to the bid-ask spread is associated with a subsequent decline in the aggregate idiosyncratic variance. The microstructure hypothesis dominates any of the alternative explanations, including uncertainty about profitability, earnings shocks, or growth options, for the trend in idiosyncratic variance