Incomplete Information, Idiosyncratic Volatility and Stock Returns

We develop a model of firm investment under incomplete information that explains why idiosyncratic volatility and stock returns are related. When the unobserved state variable proxies for the business cycles, we show that a properly calibrated version of the model generates a negative relation due to the natural asymmetry in the length of expansions and recessions. We further show that, conditional on earning surprises, the relation between idiosyncratic volatility and stock returns is positive after good news and negative after bad news. This result provides new insights on the nature of stock return predictability