The Idiosyncratic Volatility Puzzle and Asset Pricing Errors: Evidence from 600 Indonesian Equities

Abstract

This paper analyzes the nature of asset pricing errors and tests for the presence of the idiosyncratic volatility puzzle across an emerging market. Using a full cross-sectional dataset of 600 stock trades on the Indonesia Stock Exchange (IDX), we perform market model parameter estimates based on a time-series framework followed by cross-sectional econometrics. The empirical findings uncover an extremely negative cross-sectional bias in the crossing-structure cost of capital along the exchange with a 71.5% detailing (cross–segmented mean alpha = −0.001363) number of the example of organizations creating negative Jensen’s alphas —again implying that standard market betas neglect to embody both higher costs and basic danger across all exchanges on normal regardless if that effect is already examined or not. Importantly, we present a novel, statistically significant negative link between a measure of each firm's idiosyncratic risk (STEY X) and its risk-adjusted excess return (, , ). Such a constant negative premium is directly inconsistent with classical portfolio theory and provides strong evidence that the idiosyncratic volatility puzzle is a deep-rooted feature of the Indonesian equity market ecosystem. We propose that the anomaly arises from both institutional and behavioral frictions: prudential short-sale constraints result in high arbitrage costs; retail trading volume is highly concentrated among those whose speculative lottery-denominated preferences, in practice, urge them to trade; and significant corporate information asymmetries. These results support the notion that passive, beta-focused asset allocation strategies underperform systematically on the IDX and have important implications for (i) regulators attempting to enhance market efficiency and (ii) institutional portfolio managers optimizing risk-adjusted returns in Southeast Asia.

Keywords: Asset Pricing Errors, Jensen's Alpha, Idiosyncratic Volatility Puzzle, Market Efficiency, Indonesia Stock Exchange, STEY X.

JEL Classification: G11, G12, G14, G15.