This study integrates microstructure theory with asset pricing to investigates how the idiosyncratic volatility (IVOL) puzzle operates through specialized liquidity risk channels in China’s A-shares market. We employ intraday transactions data to perform a novel decomposition of liquidity into its variable (informational) and fixed (transitory) components. We show that the anomalous negative relationship between IVOL and future returns emerges from the intricate interaction of liquidity risk exposure, information and arbitrage constraints, and measurement biases. Specifically, the variable component tied to informed trading and adverse selection exposes high-IVOL stocks to greater arbitrage risk during liquidity shocks, while the fixed component exacerbates their vulnerability to short-term market-making cost fluctuations. Our results reveal that the IVOL puzzle is not a statistical artifact but a rational pricing phenomenon driven by omitted liquidity risk, mediated by the country’s unique institutional environment and monetary conditions.

Using three natural experiments, we test the hypothesis that investor overconfidence produces overpricing of high idiosyncratic volatility stocks in the presence of binding short-sale constraints. We study three events: IPO lockup expirations, option introductions, and the 2008 short-sale ban on financial firms. Consistent with our prediction, we show that when short-sale constraints are relaxed, event stocks with high idiosyncratic volatility tend to experience greater price reductions, as well as larger increases in trading volume and short interest, than those with low idiosyncratic volatility. These results hold when we benchmark event stocks with non-event stocks with comparable idiosyncratic volatility. Overall, our findings suggest that biased investor beliefs and binding short-sale constraints contribute to idiosyncratic volatility overpricing.