53 Pages Posted: 12 Nov 2012 Last revised: 15 Nov 2015
Date Written: December 2, 2014
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: 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