Correlated Idiosyncratic Volatility Shocks

Abstract

The commonality in idiosyncratic volatility cannot be fully explained by time-varying volatility; correlated idiosyncratic volatility shocks are an important contributing factor. We empirically document this fact for various characteristic-sorted portfolios and industry portfolios. To capture the commonality in idiosyncratic volatility, we propose a novel multivariate generalized autoregressive conditional heteroscedasticity (GARCH) model called dynamic factor correlation (DFC). The DFC model has a closed-form likelihood function that allows computationally cheap estimation, even for a large number of assets. The DFC model improves statistical fit compared with existing multivariate GARCH models such as the dynamic conditional correlation model and the dynamic equicorrelation (DECO) model, achieving the lowest root mean square error and mean absolute error in simulations. Empirical tests also corroborate simulations in demonstrating the improved statistical fit of the DFC model. Mean--variance portfolio optimization using the DFC model outperforms alternative volatility models such as the historical covariance matrix and the DECO model. Out-of-sample mean--variance-efficient portfolios using the DFC model have the lowest volatility and the highest Sharpe ratios, thereby improving the investor's opportunity set. Under parametric restrictions, the DFC model reduces to the constant conditional correlation model or the DECO model.

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

JEL Classification: C58, G12, G17