Is idiosyncratic volatility priced? Evidence from the Shanghai Stock Exchange

This paper employs the mimicking portfolio approach of Fama and French [J. Finance 51 (1996) 55] and asks whether idiosyncratic volatility is priced for equities listed in the Shanghai Stock Exchange (SSE). The paper also provides evidence on whether returns on small stocks are higher in January than in the remaining months. Our findings reveal that (a) idiosyncratic volatility is priced and (b) the multifactor model provides a better description of average returns than the traditional capital asset pricing model (CAPM). We also find that the absolute pricing errors of the CAPM are large when compared with the multifactor model. We argue that firm size and idiosyncratic volatility may serve as proxies for systematic risk. We also dismiss the claim that returns on small stocks are on average higher in January than in the remaining months. In summary, investors interested in taking additional risks should invest in small and low-idiosyncratic-volatility firms in addition to the market portfolio. This is because our findings indicate that investors can generate substantial returns by investing in strategies unrelated to market movements.