Idiosyncratic volatility, conditional liquidity and stock returns

There is strong evidence showing that stocks with higher levels of idiosyncratic risk provide relatively lower returns than stocks with lower levels of it. This paper points out that this negative idiosyncratic risk - expected returns relation is not pervasive over time, and provides a plausible explanation for its time-varying nature. Our results suggest that following recessions, the conditional pricing of liquidity, creates a correction in prices of the high idiosyncratic volatility stocks that persists up to 9 months. As a result, the negative relation between idiosyncratic risk and expected returns is not observed following recessions.Juliana Malagon acknowledges financial support from Universidad de Los Andes, Fondo de Apoyo para Profesores Asistentes [grant number P17.100322.004]. David Moreno acknowledges financial support from Ministerio de Ciencia y Tecnología [grant number ECO2013-42849-P]. Rosa Rodriguez acknowledges financial support from the Ministry of Economics and Competitiveness [grant number ECO2015-67035-P] and from Banco de España through the grant financing the research in macroceconomics, monetary economics finance and banking