Idiosyncratic volatility and the cross-section of abnormal returns in Pakistan

What is it about?

The study finds that the idiosyncratic volatility (IVOL) effect weakens in Pakistan, where gambling is prohibited, and individual investors are less dominant. It reveals that stocks eligible for Islamic funds exhibit different IVOL premia. Further analysis based on prospect theory shows that the lowest-IVOL stocks rebound after negative returns, while the highest-IVOL stocks underperform after positive returns, indicating sentiment-driven behaviors. Zero-investment portfolios exploiting these mispricing anomalies outperform original strategies. Ultimately, the study concludes that the IVOL premium is linked to mispricing rather than risk.

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Photo by Nick Chong on Unsplash

Photo by Nick Chong on Unsplash

Why is it important?

This study is important because it addresses the idiosyncratic volatility (IVOL) puzzle in a unique context—Pakistan—where gambling is religiously prohibited. Examining the impact of cultural and investor composition on IVOL challenges existing assumptions about mispricing in stock markets. The findings offer valuable insights for investors and fund managers, particularly in understanding how sentiment and behavioral factors influence stock performance. Additionally, it contributes to the broader literature on market anomalies and the role of investor psychology in financial markets.

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