Stocks with high idiosyncratic volatility perform poorly relative to low idiosyncratic volatility
stocks. We o
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er a novel explanation of this anomaly based on real options, which is consistent
with earlier findings on idiosyncratic volatility (the positive contemporaneous relation between
firm-level stock returns and idiosyncratic volatility). Our approach is based on introducing
stochastic idiosyncratic cash flow risk into an equity valuation model of firms with growth
options. Within our model, a firm’s systematic risk depends on the delta of its growth op-
tion. The growth option’s delta is lower when idiosyncratic volatility rises, driving down the
firm’s systematic risk and hence its expected return – firms with higher idiosyncratic volatility
therefore have lower expected returns. Our model additionally o
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ers the following novel em-
pirical predictions: (i) returns correlate positively with idiosyncratic volatility during intervals
between large changes in idiosyncratic volatility (the switch e
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ect), and (ii) the anomalies
and the switch e
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ect are stronger for firms with more real options and which undergo larger
changes in idiosyncratic volatility. Empirical results support the predictions of our model.