The Common Factor in Idiosyncratic Volatility: Quantitative Asset Pricing Implications

53 Pages Posted: 12 Nov 2012 Last revised: 15 Nov 2015

See all articles by Bernard Herskovic

Bernard Herskovic

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

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; New York University (NYU)

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Date Written: December 2, 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.

Keywords: Firm volatility, Idiosyncratic risk, Cross-section of stock returns

JEL Classification: E3, E20, G1, L14, L25

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 (December 2, 2014). Journal of Financial Economics (JFE), Forthcoming, Fama-Miller Working Paper, Chicago Booth Research Paper No. 12-54, Available at SSRN: https://ssrn.com/abstract=2174541 or http://dx.doi.org/10.2139/ssrn.2174541

Bernard Herskovic

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

Los Angeles, CA 90095-1481
United States

HOME PAGE: http://bernardherskovic.com

Bryan T. Kelly (Contact Author)

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
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AQR Capital Management, LLC ( email )

Greenwich, CT
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National Bureau of Economic Research (NBER) ( email )

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Hanno N. Lustig

Stanford Graduate School of Business ( email )

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National Bureau of Economic Research (NBER)

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Stijn Van Nieuwerburgh

Columbia University Graduate School of Business ( email )

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HOME PAGE: http://https://www0.gsb.columbia.edu/faculty/svannieuwerburgh/

National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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ABFER ( email )

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New York University (NYU) ( email )

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