Recovering Factor Volatility
45 Pages Posted: 17 May 2017 Last revised: 30 Oct 2018
Date Written: October 28, 2018
We show that any factor structure for stock returns naturally induces a factor structure for return volatility. We use this structure to propose a methodology for estimating forward-looking variances and covariances of both factors and individual assets from option prices at a high frequency. We implement the model empirically and show that our forward-looking volatility estimates provide useful implications for optimal portfolio choice and the prediction of jumps for both factors and individual stocks.
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