Idiosyncratic Volatility, Growth Options, and the Cross-Section of Returns

Abstract The value effect and the idiosyncratic volatility (IVol) discount arise because growth firms and high IVol firms beat the CAPM during periods of increasing aggregate volatility (market volatility and average IVol), that makes their risk low. All else equal, growth options’ value increases with volatility, an effect that is stronger for high IVol firms, for which growth options take a larger fraction of the firm value and firm volatility responds more to aggregate volatility changes. The factor model with the market factor, the market volatility risk factor, and the average IVol factor explains the value effect and the IVol discount. (JEL G12, G13, E44) Received August 5, 2021; editorial decision February 7, 2023 by Editor Hui Chen. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.