The effect of COVID-19 on the relationship between idiosyncratic volatility and expected stock returns

This study examines the effect of the COVID-19 pandemic on the relationship between idiosyncratic volatility and expected stock returns. Using daily stock return data in the US market from the Center for Research in Security Prices (CRSP), we estimate monthly idiosyncratic volatility and investigate the effect of the COVID-19 pandemic at the portfolio and firm level. The results of portfolio analysis and cross-sectional regression show that the relationship between idiosyncratic volatility and subsequent stock returns switches from negative to positive during the pandemic period. Furthermore, we find that the relationship is robust to skewness for the "before the pandemic" and "after pandemic" periods. On the contrary, when we control for the one-month return reversal, the effect of idiosyncratic volatility on the subsequent stock returns becomes insignificant in both periods. Therefore, the short-term return reversal effect is the underlying reason for the relationship switching from negative to positive in the pandemic period. Our results are beneficial for investors and researchers.