The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications

66 Pages Posted: 28 Apr 2014 Last revised: 11 May 2023

See all articles by Bernard Herskovic

Bernard Herskovic

University of California, Los Angeles (UCLA) - Anderson School of Management; National Bureau of Economic Research (NBER)

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Stijn Van Nieuwerburgh

Columbia University Graduate School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); ABFER

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Date Written: April 2014

Abstract

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.

Suggested Citation

Herskovic, Bernard and Kelly, Bryan T. and Lustig, Hanno N. and Van Nieuwerburgh, Stijn, The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications (April 2014). NBER Working Paper No. w20076, Available at SSRN: https://ssrn.com/abstract=2430071

Bernard Herskovic (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

Los Angeles, CA 90095-1481
United States

HOME PAGE: http://bernardherskovic.com

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Bryan T. Kelly

Yale SOM ( email )

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AQR Capital Management, LLC ( email )

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Hanno N. Lustig

Stanford Graduate School of Business ( email )

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Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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