Corporate hedging and the high idiosyncratic volatility low return puzzle

The literature offers various explanations to either support or refute the Ang et al. (2006) high idiosyncratic volatility low return puzzle. Fu (2009) finds a significantly positive contemporaneous relation between return and exponential generalized autoregressive conditional heteroskedastic idiosyncratic volatility. We use corporate hedging to shed light on this puzzle. Conceptually, idiosyncratic volatility matters to investors who face limits to diversification. But limits to diversification become less relevant for firms that consistently hedge. We confirm the main finding in Fu (2009), but only for firms that do not consistently hedge. For firms that adopt a consistent hedging policy, idiosyncratic volatility, whether contemporaneous or lagged, is insignificant in Fama–MacBeth regressions, controlling for size, book-to-market, momentum, liquidity, and industry effects.