The Effect of Idiosyncratic Volatility and the Role of Investors' Sentiment in the Swedish Stock Market

Abstract: The thesis investigates the presence of arbitrage risk and arbitrage asymmetry, and their relation with investors' sentiment, in the Swedish stock market. By assuming that stocks' idiosyncratic volatility (IVOL) translates into arbitrage risk, the study analyzes the effects of IVOL on subsequent returns for the OMX Stockholm 30 constituents. Relevant literature suggests that stocks with the highest-IVOL are the most mispriced - either overpriced or underpriced -, and arbitrage risk is stronger for high-IVOL overpriced than for high-IVOL underpriced stocks due to arbitrage asymmetry. After dividing the sample stocks in two categories of mispricing, the analysis finds that, because of arbitrage risk, the highest-IVOL stocks tend to be contemporaneously the most overpriced, within the group of overpriced stocks, and the most underpriced, within the group of underpriced stocks. This suggests the existence of a negative effect of IVOL on subsequent returns among overpriced stocks and a positive IVOL effect among underpriced stocks. Furthermore, by introducing a sentiment index, the thesis finds a negative relation between investors' sentiment and IVOL effect: despite low levels of significance, the negative IVOL effect among overpriced stock is stronger in high-sentiment periods, while the positive IVOL effect among underpriced stock is stronger in low-sentiment periods. This also implies that arbitrage asymmetry is more relevant in high-sentiment periods. Most importantly, even after controlling for macroeconomic variables, the results confirm the role of pure investors' sentiment, implying that behavioral aspects primarily influence the extent of arbitrage limits.