Correlated Idiosyncratic Volatility Shocks

33 Pages Posted: 24 Aug 2016 Last revised: 9 Jan 2019

See all articles by Xiao Qiao

Xiao Qiao

Paraconic Technologies US Inc.

Yongning Wang

University of Chicago - Booth School of Business

Date Written: August 17, 2016

Abstract

Commonality in idiosyncratic volatility cannot be completely explained by time-varying volatility. We decompose the common factor in idiosyncratic volatility (CIV) of Herskovic et al. (2016) into two components: idiosyncratic volatility innovations (VIN) and time-varying
idiosyncratic volatility (TVV). VIN is priced in the cross section of stock returns, whereas TVV is weakly priced. A long-short strategy based on double-sorted VIN and TVV portfolios earns average returns of 8.0% per year. To capture the commonality in idiosyncratic volatility, we propose the Dynamic Factor Correlation model, which outperforms Engle’s (2002) DCC model in simulations and empirical tests.

Keywords: volatility, GARCH, cross section, stock returns, idiosyncratic risk

JEL Classification: C58, G12, G17

Suggested Citation

Qiao, Xiao and Wang, Yongning, Correlated Idiosyncratic Volatility Shocks (August 17, 2016). 29th Australasian Finance and Banking Conference 2016. Available at SSRN: https://ssrn.com/abstract=2825700 or http://dx.doi.org/10.2139/ssrn.2825700

Xiao Qiao (Contact Author)

Paraconic Technologies US Inc. ( email )

New York, NY
United States

HOME PAGE: http://sites.google.com/site/xiaoqiao10/

Yongning Wang

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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