′Idiosyncratic Volatility Puzzle′

The paper must cover two bodies of literature: (1) overview of the main models for asset valuation starting with the CAPM (1964) (2) empirical studies testing the influence of idiosyncratic risk on asset′s expected return (and hence on their valuation) Under point (2) the paper by Ang et al. (2006) ″The Cross-Section of Volatility and Expected Returns″ in Journal of Finance must appear as a watershed moment. This paper highlighted the ′Idiosyncratic Volatility Puzzle′, i.e. there appears to be a negative correlation between volatility and expected returns, which created a marked renewed scholarly interest in the topic. The studies trying to explain the ′Idiosyncratic Volatiliy Puzzle′ must further be grouped in following four categories: (a) papers explaining the puzzle as a behavioral anomaly by irrational investors (b) papers looking for solution in better mathematics, i.e. trying to improve forward looking measures by correcting for volatility clusters, return reversals and other features (using GARCH or other approaches) (c) papers arguing the idiosyncratic volatility, as measured, does not represent risk but rather transparency by the company (i.e. more news equals more volatility), which would explain the negative correlation (d) papers arguing that idiosyncratic volatility represents uncertainty (via increased short-term arbitrageurs in the shareholder base) – note that since transparency is negatively correlated with uncertainty this last explanation is at odds with the previous one! Attached are also two documents that should be useful: (i) ″lit list″ ＝ presentation including a list of key publications that should be included for each body of literature (see slides 3 and 6) (ii) ″example″ ＝ thesis that covers the same ground in its chapter 2 ′related studies′ albeit from another angle