Title: Idiosyncratic volatility and average stock returns: evidence from Sri Lanka

Authors: H.A.P.K. Perera; Tharindu Chamara Ediriwickrama

Addresses: Department of Finance, Faculty of Management and Finance, University of Colombo, Sri Lanka ' Department of Finance, Faculty of Management and Finance, University of Colombo, Sri Lanka

Abstract: Conventionally, it is believed that the idiosyncratic volatility should not be priced at market equilibrium as it can be eliminated through diversification. Despite the presence of inconsistent empirical evidence on idiosyncratic volatility, the current study aims to investigate the presence of idiosyncratic volatility from a frontier market such as Sri Lanka. Employing the Fama and French five-factor model together with the exponential generalised autoregressive conditional heteroskedasticity (EGARCH), the conditional idiosyncratic volatility of individual stocks of non-financial firms listed on the Colombo Stock Exchange (CSE) was estimated. This study reveals the presence of idiosyncratic volatility of stocks in Sri Lanka. The results further indicate though the idiosyncratic volatility of stocks is useful in explaining the average stock returns, it is still questionable as to why there is a demand in the market for small stocks with high idiosyncratic volatility since the critical weaknesses in asset pricing models are mostly coupled with the small stocks.

Keywords: Colombo Stock Exchange; EGARCH; five-factor asset pricing model; frontier market; idiosyncratic volatility; Sri Lanka.

DOI: 10.1504/AAJFA.2021.119482

Afro-Asian Journal of Finance and Accounting, 2021 Vol.11 No.5, pp.740 - 754

Received: 22 Mar 2020
Accepted: 02 Nov 2020
Published online: 07 Dec 2021 *

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