Idiosyncratic volatility in the Australian equity market

This paper studies the idiosyncratic volatility (N) puzzle in the Australian equity market. I document a negative relation between IV and future stock returns. More importantly, this is the first Australian study to investigate the role of the asset-pricing model used to estimate IV. While recent work advocates a five-factor model incorporating investment and profitability factors, the findings suggest that the IV puzzle is not an outcome of investment and profitability factors being omitted from the three-factor model used to estimate IV. The exploration of potential causes of the IV puzzle suggests that it is attributable to mispricing, since it concentrates amongst the most overpriced stocks as given by an Australian mispricing index. Decomposing the source of mispricing, the N puzzle is largely explained by investors' preference for lottery-like stocks.