The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications

Bernard Herskovic, Bryan T. Kelly, Hanno Lustig, Stijn Van Nieuwerburgh

NBER Working Paper No. 20076
Issued in April 2014
NBER Program(s):   AP

We show that firms’ idiosyncratic volatility obeys a strong factor structure and that shocks to the common factor in idiosyncratic volatility (CIV) 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. These three facts 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 comovement in idiosyncratic volatilities, the CIV-beta return spread, and several other asset price moments.

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This paper was revised on December 8, 2014

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Document Object Identifier (DOI): 10.3386/w20076

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