Understanding the return-reversal phenomenon observed to generate large abnormal profits under
some stock market trading strategies is of considerable interest in finance. There is also much
debate over the use of idiosyncratic risk as a predictor in asset pricing models when it is persistent.
This paper, using the Australian data, presents new empirical evidence of return-reversals at the
firm level and the existence of an equilibrium state based on robust econometric methodology
of panel error-correction model. The method exploits the persistence in idiosyncratic risk and
builds on its cointegration with the returns series. Our results reveal the tendency of long-run
returns to restore equilibrium, reversals in short-run returns, a slower recovery to equilibrium by
small stocks, and while the short-run responses of returns to changes in log book-to-market ratios
are positive, their reaction to persistence in idiosyncratic volatility causes the reversal process.
The pattern in quantile dependent coefficients of short-run idiosyncratic risk-return relationship
suggests that (i) the changes in idiosyncratic volatility risk adversely affects the short-run returns
of low performing stocks but investments in high performing stocks benefit from such changes;
(ii) the increasing trend in the coefficients implies a quadratic relationship in the levels of the two
series. The significant marginal effects of changes in idiosyncratic volatility and its one period
lagged values on changes in returns at many quantiles support the impact being due to persistence
in idiosyncratic risk, and their reversing signs provide an evidence of reversion in short-run
returns.
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