The common factor in idiosyncratic volatility: Quantitative asset pricing implications

Bernard Herskovic, Bryan Kelly, Hanno Lustig and Stijn Van Nieuwerburgh

Journal of Financial Economics, 2016, vol. 119, issue 2, 249-283

Abstract: We show that firms׳ idiosyncratic volatility obeys a strong factor structure and that shocks to the common idiosyncratic volatility (CIV) factor are priced. Stocks in the lowest CIV-beta quintile earn average returns 5.4% per year higher than those in the highest quintile. The CIV factor helps to explain a number of asset pricing anomalies. We provide new evidence linking the CIV factor to income risk faced by households. Our findings are consistent with an incomplete markets heterogeneous agent model. In the model, CIV is a priced state variable because an increase in idiosyncratic firm volatility raises the average household׳s marginal utility. The calibrated model matches the high degree of co-movement in idiosyncratic volatilities, the CIV-beta return spread, and several other asset price moments.

Keywords: Firm volatility; Idiosyncratic risk; Cross section of stock returns (search for similar items in EconPapers)
JEL-codes: E44 G12 G17 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (140)

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Working Paper: The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:119:y:2016:i:2:p:249-283

DOI: 10.1016/j.jfineco.2015.09.010

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