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What Explains the Idiosyncratic Volatility in the Korean Stock Market?

Using the Fama-French three-factor model, this paper provides an explanation for the variation of idiosyncratic return in the Korean stock market over the period of 1990-2012. There had been an upward trend until 1999 in idiosyncratic volatility and its trend has been reversed afterwards. Our analysis yields three main results. Firstly, it appears that all four explanatory variables, two fundamentals related variables of the variance of return on equity and a proxy of growth options and two trading volume related variables of trading volume and foreign ownership ratio, explain considerable proportion of idiosyncratic return variation. Most interestingly, foreign investors have stabilizing effect on firm-specific risk in the Korean stock market. Secondly, a firm’s characteristics such as size and export orientation exert some influence on idiosyncratic volatility. While the role of variance of ROE is comparatively stable across both the sample periods and the group of stocks, growth options and foreign ownership ratio are more explanatory in large companies and major export industries. Lastly, the absolute and relative explanatory powers of the four explanatory variables vary through time and diminish as the sample period ends, implying the need to search for further explanatory variables.