On ethnicity of idiosyncratic risk and stock returns puzzle

Abstract

Purpose – The purpose of this paper is to understand the controversial issue of whether stock returns and idiosyncratic risks are related positively or negatively in case of Singaporean ethically poor screened stocks. Design/methodology/approach – To achieve the major objectives of this paper, it uses a multiple regression to explore the relationship between expected stock returns and idiosyncratic risk. The paper replicates the Lee and Faff’s (2009) three-factor capital asset-pricing model (CAPM) model in creating the six size/book-to-market portfolios from which it constructs the small minus big (SMB) and high minus low (HML) portfolios that capture the size and book-to-market equity factors, respectively. Findings – The basic finding of the paper is that there is a strong relation between idiosyncratic risk and the expected stock returns. In more details, we observe that the portfolio of stocks with the highest idiosyncratic volatility generates higher average returns (4.36 per cent) than the portfolio of stocks with the lowest idiosyncratic volatility (0.79 per cent) over the sample period. The paper observes that the stock’s idiosyncratic volatility is inversely correlated with the size of the underlying firm. Moreover, there is a pattern of relationships nearer the periods of financial crises: Asian and global financial crises. Research limitations/implications – This paper uses only a three-factor model on a single country. So it cannot be generalized to a multi-country level in the Association of Southeast Asian Nations (ASEAN) region, as the structure of each member country is different. Practical implications – This paper provides guidelines for policymakers and foreign investors in Singapore about the relationship. This research can also be extended to other ASEAN countries to understand this puzzle. Social implications – Ethically sensitive and faithful investors with small investment can benefit from the findings of this paper. Originality/value – The work reported in this paper is original, unpublished and is also not under consideration for publication elsewhere.