Idiosyncratic Volatility, Growth Options, and the Cross-Section of Returns
68 Pages Posted: 10 Nov 2007 Last revised: 7 Apr 2020
Date Written: April 6, 2020
The paper shows that the value effect and the idiosyncratic volatility (IVol) discount (Ang et al., 2006) arise because growth firms and high IVol firms beat the CAPM during the periods of increasing aggregate volatility, which makes their risk low. All else equal, growth options' value increases with volatility, and this effect is stronger for high IVol firms, for which both growth options take a larger fraction of the firm value and firm volatility responds more to aggregate volatility changes. The three-factor ICAPM with the market factor, the market volatility risk factor (FVIX) and the average IVol factor (FIVol) completely explains the value effect and the IVol discount. The three-factor ICAPM also explains why those anomalies are stronger for firms with high short sale constraints.
Keywords: idiosyncratic volatility discount, growth options, aggregate volatility risk, value premium, anomalies, real options
JEL Classification: G12, G13, E44
Suggested Citation: Suggested Citation