Idiosyncratic volatility and security returns: evidence from Germany and United Kingdom

Purpose Malkiel and Xu state that idiosyncratic volatility is highly correlated with size and that it plays a powerful role in explaining expected returns. The purpose of this paper is to ask whether idiosyncratic volatility is useful in explaining the variation in expected returns; and whether the findings can be explained by the turn of the year effect. Design/methodology/design Monthly stock returns and market values of all listed firms in Germany and UK covering the period 1991-2001 from Datastream are used as the basis of the evaluation. Findings The paper finds that the three-factor model provides a better description of expected returns than the Capital Asset Pricing Model (CAPM). That is, it is found that firm size and idiosyncratic volatility are related to security returns. In addition, it is noted that the findings are robust throughout the sample period Originality/value The paper shows that the CAPM beta alone is not sufficient to explain the variation in stock returns.