Reinvestigate the Bid-Ask Bounce Effect and Pricing of Idiosyncratic Volatility: The Case of the Australian Market

We investigate the bid-ask bounce effect on estimation of idiosyncratic volatility (IVOL) from asset pricing perspective using a comprehensive country-specific sample. We find that the idiosyncratic volatility-return relationship remains significant while controlling for stock size. However, the explanatory power of IVOL disappears completely when stock liquidity is controlled for. These findings support our argument that the bid-ask bounce effect on pricing of IVOL is strongly influenced by stock liquidity. Our results indicate that mid-price is the "true" price to measure IVOL of the least liquid stocks in the Australian stock market.