  This paper considers liquidity as an explanation for the positive association
between expected idiosyncratic volatility (IV) and expected stock returns.
Liquidity costs may affect the stock returns, through bid-ask bounce and other
microstructure-induced noise, which will affect the estimation of IV. We use a
novel method (developed by Weaver, 1991) to eliminate microstructure influences
from stock closing price-based returns and then estimate IV. We show that there
is a premium for IV in value-weighted portfolios, but this premium is less
strong after correcting returns for microstructure bias. We further show that
this premium is driven by liquidity in the prior month after correcting returns
for microstructure noise. The pricing results from equally-weighted portfolios
indicate that IV does not predict returns either before or after controlling
for liquidity costs. These findings are robust after controlling for common
risk factors as well as analysing double-sorted portfolios based on IV and
liquidity.
