The Systematic Risk of Idiosyncratic Volatility

45 Pages Posted: 5 Aug 2011 Last revised: 13 Apr 2014

Jefferson Duarte

Rice University

Avraham Kamara

University of Washington - Michael G. Foster School of Business

Stephan Siegel

University of Washington - Michael G. Foster School of Business

Celine Sun

Wealthfront, Inc.

Date Written: April 11, 2014

Abstract

We show that the pricing of idiosyncratic volatility (IV) is due to unaccounted systematic risk, which affects a large number of asset pricing anomalies. A single common IV component explains one third of variation in IV. Mispricing arises when sorting stocks by the part of IV predicted by exposure to the common IV component, but not when sorting by residual IV. We propose the return difference between stocks with high and low predicted IV, PIV, as a proxy for the missing risk factor. PIV is significantly related to the common components of the returns of several important anomaly-based trading strategies. Controlling for PIV helps explain the earnings surprise, net stock issues, profitability, as well as illiquidity anomalies, and completely explains the financial distress anomaly. Overall our results suggest that the IV puzzle reflects systematic risk related to the average stock volatility and credit risk.

Suggested Citation

Duarte, Jefferson and Kamara, Avraham and Siegel, Stephan and Sun, Celine, The Systematic Risk of Idiosyncratic Volatility (April 11, 2014). Available at SSRN: https://ssrn.com/abstract=1905731 or http://dx.doi.org/10.2139/ssrn.1905731

Jefferson Duarte

Rice University ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States
713.3486137 (Phone)

Avraham Kamara (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States
206-543-0652 (Phone)
206-221-6856 (Fax)

Stephan Siegel

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

HOME PAGE: http://faculty.washington.edu/ss1110/

Celine Sun

Wealthfront, Inc.

900 Middlefield Rd
Redwood City, CA 94063
United States

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