Idiosyncratic risk in the South African stock market
Date
2023-08
Authors
Journal Title
Journal ISSN
Volume Title
Publisher
University of the Witwatersrand, Johannesburg
Abstract
Traditional finance theory posits that risk and return are linearly related. Higher returns are to be expected with greater risks. Modern portfolio theory champions for diversification of portfolios, which reduces risks unique to a firm to zero. This unique risk is known as idiosyncratic risk. Studies have come along and challenged the conventional wisdom in finance. Several studies have found that idiosyncratic risk is compensated for in many markets, partly due to poor diversification opportunities and partly because market risk alone is not sufficient to explain returns.
This study tests if lagged idiosyncratic risk is associated with stock returns in the South African stock market for the period between 2001 and 2022. The study examines if investors are compensated, through higher returns, for holding firm-specific risk, in a market where full diversification may not be possible. This study also adds to the ongoing discussion on the degree and importance of price anomalies in an emerging stock market as well as the impact of idiosyncratic risk in determining predicted stock returns.
This study utilizes a portfolio strategy that buys stocks with high idiosyncratic volatility and shorts stocks with low idiosyncratic volatility. The rationale for this is that if investors are compensated for assuming higher unsystematic risk, the alpha of this long-short portfolio should be positive and significant. This study instead found the opposite, which is that the alpha’s of these portfolios were negative and statistically significant. This suggests that investors who hold stocks with lower idiosyncratic volatility are compensated more than investors who hold stocks with higher idiosyncratic volatility. The robustness checks confirm this finding, as it was noted that portfolios continue to have statistically significant alphas following months of low volatility, with the long-short IVOL portfolios outperforming all other portfolios. The alphas remain negative and significant even when controlling for size and value in two-way sorts. Idiosyncratic volatility is therefore negatively related to stock returns, a puzzling result
Description
A research report submitted in partial fulfilment of the requirements for the degree of Master of Commerce – (Business Finance) in the school of economics and finance at the University of the Witwatersrand, Johannesburg, 2023
Keywords
Traditional finance theory, Risks, Idiosyncratic risk, Finance, Stocks returns, UCTD
Citation
Scrooby, Caleb. (2023). Idiosyncratic risk in the South African stock market [Master’s dissertation, University of the Witwatersrand, Johannesburg]. WireDSpace.