When Does Idiosyncratic Volatility Matter? Geopolitical Risk, Mispricing, and Drivers in Frontier Markets

We examine the idiosyncratic volatility (IVOL) puzzle by examining its conditional manifestation in frontier African equity markets. Using a comprehensive panel of 107,684 firm-month observations spanning 2010 to 2024 across ten African markets, we investigate the drivers of idiosyncratic volatility and its cross-sectional pricing, with particular attention to geopolitical risk, market structure, and firm characteristics. IVOL is estimated from Fama-French factor models, and Fama-MacBeth regressions are employed to assess both unconditional and conditional return relations. We document pronounced heterogeneity: firm-level characteristics, illiquidity, lottery-like payoffs (MAX), macroeconomic instability, and geopolitical factors significantly drive IVOL, with effects amplified in markets exhibiting high political instability or civil unrest. Conditional analyses reveal that the negative IVOL-return relation emerges predominantly in high political instability and low civil unrest regimes and among overpriced stocks, while disappearing in low-risk or underpriced contexts. These findings suggest that the IVOL puzzle reflects mispricing and limits to arbitrage rather than compensation for undiversifiable risk, consistent with behavioral and friction-based theories of asset pricing. By integrating geopolitical risk and frontier market conditions, our study reconciles mixed evidence in the literature and demonstrates that IVOL pricing is fundamentally state-dependent. The results have important implications for asset pricing models, portfolio construction, and risk management in emerging and frontier markets, highlighting the need to account for conditional heterogeneity and local market frictions when interpreting volatility-driven anomalies. This research extends global understanding of the IVOL puzzle, emphasizing the interplay among investor behavior, market microstructure, and geopolitical contingencies in shaping the dynamics of frontier-market asset pricing.