Session Chair: Andrea Tamoni, London School of Economics
Tax-Timing Options and the Demand for Idiosyncratic Volatility
Oliver Boguth, Luke Stein
Arizona State University
Discussant: Martijn Boons (Nova School of Business and Economics)
Investors have a choice over when to incur taxes on individual investments, and typically benefit from delaying the realization of capital gains while harvesting losses. This option implies that the effective tax rate on capital losses exceeds the one on capital gains, resulting in a convex after-tax payoff. Convexity creates a demand for idiosyncratic volatility (IVOL) within a well-diversified portfolio, and can therefore explain the puzzling negative relation between IVOLand expected stock returns. A simple model with tax-timing options predicts that the demand for idiosyncratic volatility increases with the tax rate, the nominal interest rate, and unrealized capital gains, and we show that all three measures predict the IVOL premium in the time-series. In the cross-section, we show that the magnitude of the IVOL premium increases with investors' average tax exposure.
Idiosyncratic Risk Matters to Large Stocks!
Yangqiulu Luo1, Guojun Wu1, Yexiao Xu2
1University of Houston; 2University of Texas at Dallas
Discussant: Amit Goyal (University of Lausanne)
Despite the debate on the pricing of idiosyncratic risk, it is generally believed that the pricing effect is likely to exist among small stocks due to lack of diversification and information asymmetry predicted by Merton (1987). However, given the size of Asset Under Management, most institutional investors focus on large stocks and hold portfolios different from that of the market portfolio in order to attract investors and to differentiate themselves. Moreover, large stocks will have a larger impact on the performance of a portfolio than small stocks, and institutional investors are more likely to be questioned when large stocks perform poorly. These unique features can forced institutional investors to care about idiosyncratic risk of larger stocks more than that of small stocks in their portfolio. Recognizing this important difference on the impact of idiosyncratic risk, we take an unorthodox approach by focusing on the effect of idiosyncratic risk within different groups of stocks. As a result, we find that large stocks' idiosyncratic volatilities indeed are positively related to their future stock returns, while small stocks idiosyncratic volatilities are negatively related to their future returns as documented. This finding also allows us to reconcile the inconsistent findings on the pricing of idiosyncratic risk in the current literature.
Good Volatility, Bad Volatility, and the Cross-Section of Stock Returns
Tim Bollerslev1, Sophia Zhengzi Li2, Bingzhi Zhao1
1Duke University; 2Michigan State University
Discussant: Riccardo Sabbatucci (Stockholm School of Economics)
Based on intraday data for a large cross-section of individual stocks and newly developed econometric procedures, we decompose the realized variation for each of the stocks into separate so-called realized up and down semi-variance measures, or "good" and "bad" volatilities, associated with positive and negative high-frequency price increments, respectively. Sorting the individual stocks into portfolios based on their normalized good minus bad volatilities results in economically large and highly statistically significant differences in the subsequent portfolio returns. These differences remain significant after controlling for other firm characteristics and explanatory variables previously associated with the cross section of expected stock returns.