Is Idiosyncratic Volatility Priced? Evidence from the Shanghai Stock Exchange

This paper employs the mimicking portfolio approach of Fama and French (1996) and asks whether idiosyncratic volatility is priced. This paper also provides evidence on whether returns on small stocks are higher in January than in remaining months. Our findings reveal that (a) idiosyncratic volatility is priced; and, (b) the multifactor model provides a better description of average returns than the traditional CAPM. We also find that the absolute pricing errors of the CAPM are large when compared with the multifactor model. We argue that firm size and idiosyncratic volatility may serve as proxies for systematic risk. We also dismiss the claim that returns on small stocks are on average higher in January than in remaining months. In summary, investors interested in taking additional risks should invest in small and low idiosyncratic volatility firms in addition to the market portfolio. This is because our findings indicate that investors can generate substantial returns by investing in strategies unrelated to market movements. Keywords: Idiosyncratic Volatility, Firm Size, Asset