Time-varying moments, idiosyncratic risk, and an application to hot-issue IPO aftermarket returns

This paper proposes time-varying idiosyncratic risk as a component driving conditional abnormal returns and outlines a corresponding Engle et al. [Econometrica 55 (1987) 391] ARCH-M market model. An application is given to initial public offering (IPO) aftermarket stock returns, where a positive relation between idiosyncratic risk and returns is consistent with young issues’ equity as a contingent claim on firm assets. The empirical results for an illustrative sample of German Neuer Markt stocks traded during the first two years after initial listing indicate pronounced skewness as well as a positive relation between conditional idiosyncratic risk and expected returns. Conditioning aftermarket performance on risk yields much lower levels of abnormal return significance than a standard approach.