Earnings Shocks and the Idiosyncratic Volatility Anomaly in the Cross- Section of Stock Returns

Ang, Hodrick, Xing, and Zhang (2006, 2009) document a puzzling negative relation between idiosyncratic volatility and cross-section of stock returns. This paper examines whether this idiosyncratic volatility discount is related to earnings shocks, and finds that a substantial portion of the idiosyncratic volatility discount can be explained by earnings momentum and post-formation earnings shocks. When these two effects are accounted for, idiosyncratic volatility has little, if any, return predictability. In addition, earnings momentum alone can explain at least 42% of the idiosyncratic volatility discount. * I am grateful for comments from René Stulz and seminar participants at The Ohio State University. I would like to thank my advisor, Kewei Hou, for the considerable amount of time he has spent discussing this topic with me. Author’s email address: [email protected].