Expected idiosyncratic entropy

Abstract

PurposeWe propose a risk factor for idiosyncratic entropy and explore the relationship between this factor and expected stock returns.Design/methodology/approachWe estimate a cross-sectional model of expected entropy that uses several common risk factors to predict idiosyncratic entropy.FindingsWe find a negative relationship between expected idiosyncratic entropy and returns. Specifically, the Carhart alpha of a low expected entropy portfolio exceeds the alpha of a high expected entropy portfolio by −2.37% per month. We also find a negative and significant price of expected idiosyncratic entropy risk using the Fama-MacBeth cross-sectional regressions. Interestingly, expected entropy helps us explain the idiosyncratic volatility puzzle that stocks with high idiosyncratic volatility earn low expected returns.Originality/valueWe propose a risk factor of idiosyncratic entropy and explore the relationship between this factor and expected stock returns. Interestingly, expected entropy helps us explain the idiosyncratic volatility puzzle that stocks with high idiosyncratic volatility earn low expected returns.