Volatility Effect and the Role of Firm Quality Factor in Returns: Evidence from the Indian Stock Market

In the study, we examine if there are any volatility patterns in stock returns for India with the following objectives: to test if the volatility anomaly exists for the Indian equity market, to evaluate if such an anomaly can be explained by various asset pricing models, and to verify if the firm quality factor can explain the volatility effect in the absence of empirical success of risk models. Data is employed for 493 companies that form part of the BSE 500 index, from March 2000 to November 2013. Our results are consistent with the theory, and negate the volatility anomaly argument observed in previous international work. Consistent with theory, high volatility stocks significantly outperform low volatility stocks. Alternative risk models fail to explain the volatility effect. Consistent with prior research, we confirm the role of firm quality factor in explaining these volatility patterns. Cash flow variability seems to be a more appropriate measure of firm quality as compared to profitability. The research is pertinent for global fund managers, policy makers, as well as the academic community. From an investment perspective, there is a volatility effect, but it does not pose any serious challenge to asset pricing. Thus, the profitability of volatility based trading strategies may be debatable in the Indian environment. From the policymaker’s perspective, it provides some understanding of volatility patterns in returns as well as the institutional investor response to this information. Emerging markets like India, owing to low dividend paying behaviour of firms, exhibit high return volatility as investors focus more on the capital gains component. These investors prefer firms with higher quality (low cash flow variability), and at the same time chase more volatile stocks in pursuit of higher returns. For the academic community, the study provides several results inconsistent with prior literature.