A parsimonious five-factor model for the Indian stock market: revisiting the idiosyncratic volatility anomaly

What the paper says

Purpose The present study aims to test the idiosyncratic volatility anomaly and examine whether a factor-mimicking hedge portfolio, HIMLI, generates significant abnormal average returns. Moreover, it investigates whether this factor-mimicking portfolio contains peculiar information that can explain variations in average stock returns. Finally, it introduces the idiosyncratic volatility-based factor-mimicking portfolio as a new factor into the existing empirical asset pricing framework to explore a parsimonious asset pricing model for the Indian stock market. Design/methodology/approach This study comprises S&P BSE 500 index constituent firms. It uses a blend of parametric and non-parametric approaches involving bivariate portfolio analysis and time-series regressions with independent sample tests based on robust standard errors. Findings This study confirms the “idiosyncratic volatility effect,” i.e. idiosyncratic volatility is positively related to expected stock returns. The tests of augmented empirical asset pricing models show that the idiosyncratic volatility-based HIMLI factor contains unique information that substantiates the performance of existing asset pricing models. Originality/value This study proposes a parsimonious five-factor model comprising market, size, value, momentum and idiosyncratic volatility factors that outperform the other selected models in India. The results have important implications for retail investors, portfolio managers, and policymakers.