Fundamental volatility and stock returns : does fundamental volatility explain stock returns?

Abstract

In this thesis, we investigate whether the fundamental uncertainty can explain the crosssection of stock returns. To measure the fundamental uncertainty, we estimate rolling standard deviations and accounting betas of four different fundamentals: revenues, gross profit, earnings and cash flows. The standard deviation and the beta of revenues significantly explain returns in the Fama-Macbeth procedure, but only appears significant among smaller stocks in the portfolio formation procedure. The beta of gross profit is the only measure that we found to be significantly explaining stock returns in both procedures across sizes, when we exclude penny stocks. Interestingly, firms with low fundamental volatility appear to earn higher returns compared to firms with high fundamental volatility. We also find that investing in firms with low fundamental volatility effectively reduces the exposure to idiosyncratic risk.