Idiosyncratic Volatility pricing by explaining arbitrage risk

According to modern portfolio theory, investors can control idiosyncratic volatility via diversification of investing portfolio. Therefore, it is assumed that investors seeking for returns just because of systematic risk tolerance. However, it is practically observed that the idiosyncratic volatility has a price which is inconsistent with assumptions of modern portfolio theory. The relationship between idiosyncratic volatility and expected returns as well as the factors affecting pricing of idiosyncratic volatility has been studied so far. In this study, it is tried to test how the idiosyncratic volatility is priced in Iran’s capital market by explaining arbitrage risk during the time period of 1386-1396. For this purpose, one of the current trading restriction in Iran’s capital market as well as other common measurement variables and Fama and French five-factor model are used in estimating arbitrage risk and idiosyncratic volatility, respectively. For the first time in this study, Fama and French five-factor model as well as arbitrage risk are utilized in order to price the idiosyncratic volatility and asset, respectively. To answer the research question as well as test the hypothesis, portfolio analysis methods and Fama-MacBeth regression are utilized. Considering arbitrage risk, the results indicate that the relation between idiosyncratic volatility and expected return is meaningfully negative.