Stock volatility and asset pricing in the Hong Kong stock market

Abstract

This study provides a comprehensive investigation into the role of both total volatility (TV) and idiosyncratic volatility (IV) in asset pricing in the Hong Kong stock market over the period 1980 to 2007. Total volatility is measured by the standard deviation of past daily returns and idiosyncratic volatility is measured by the standard deviation of residuals from the Fama-French (1993) model following Ang et al. (2006, 2009). This study relates 1-month lagged idiosyncratic volatility (total volatility) to the current month’s portfolio return. First, results suggest that the equal-weighted average idiosyncratic volatility (total volatility) of Hong Kong stocks increased over our study period but market volatility declined. However, if the whole sample period is divided into two sub-periods, pre- and post-Asian financial crisis, TV and IV both trend downward in both sub-periods. The reason is that the HK stock market had a structural change after the Asian financial crisis. Second, the average equal- and value-weighted firm-level idiosyncratic volatility (total volatility) cannot predict one-month ahead excess market returns. Third, this study documents a strong positive relationship between idiosyncratic volatility (total volatility) and abnormal returns, similar to the findings of Malkiel & Xu (2006) and Fu (2009) in US stock markets, and Brockman et al.’s (2010) findings in the Hong Kong stock market. More importantly, we also find that investors could generate higher portfolio returns by using IV to sort portfolios rather than using TV. Our results are robust to controls for size, value, momentum, short-term reversal, dividend yield, price-earnings ratio, turnover ratio, AltmanZ ratio, number of zero volume, and number of zero returns, and are also robust in sub-period analysis. Moreover, the significant positive IV effect in the HK stock market is also robust to the use of weekly data in computing IV. The results imply that: 1) the correlation among stocks in the Hong Kong market has declined over time, which means an increase in the benefits from diversification; 2) firm-level measures of idiosyncratic volatility cannot be used to predict market returns; 3) that investors in the Hong Kong stock market can systematically increase their portfolio returns by going long on stocks with high IV and short on stocks with low IV.