The Common Components of Idiosyncratic Volatility

Abstract:     
Current asset pricing literature describes several anomalies that generate abnormal returns relative to Fama and French (1993) (see Cochrane (2011). We advance that a new factor, PIV (predicted idiosyncratic volatility), which is based on common components extracted from stocks' idiosyncratic volatilities and covaries with business cycles, helps explain some of these anomalies. Specifically, adding PIV to a pricing model that includes the three Fama-French factors, momentum and a liquidity factor, resolves or significantly attenuates the earnings surprise, financial distress, net stock issues, profitability, and illiquidity anomalies. Our evidence suggests that it is important to include PIV when testing asset pricing anomalies and that most of the pricing puzzle of IV sorted portfolios (see Ang, Hodrick, Xing and Zhang (2006)) is due to unaccounted systematic risk.

Number of Pages in PDF File: 39

working papers series