Arbitrage Pricing Theory for Idiosyncratic Variance Factors

61 Pages Posted: 9 Nov 2017 Last revised: 23 Sep 2019

See all articles by Eric Renault

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics

Thijs van der Heijden

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Bas J. M. Werker

Tilburg University - Center for Economic Research (CentER)

Date Written: September 20, 2019

Abstract

We develop an Arbitrage Pricing Theory framework extension to study the pricing of squared returns/volatilities. We analyze the interplay between factors at the return level and those in idiosyncratic variances. We confirm the presence of a common idiosyncratic variance factor, but do not find evidence that this represents a missing risk factor at the (linear) return level. Thereby, we consistently identify idiosyncratic returns. The price of the idiosyncratic variance factor identified by squared returns is small relative to the price of market variance risk. The quadratic pricing kernels induced by our model are in line with standard economic intuition.

Keywords: Common Volatility Factors, Option Prices, Nonlinear Pricing Kernels, Arbitrage Pricing Theory

JEL Classification: C58, G12

Suggested Citation

Renault, Eric and van der Heijden, Thijs and Werker, Bas J.M., Arbitrage Pricing Theory for Idiosyncratic Variance Factors (September 20, 2019). Available at SSRN: https://ssrn.com/abstract=3065854 or http://dx.doi.org/10.2139/ssrn.3065854

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

Thijs Van der Heijden (Contact Author)

University of Melbourne - Department of Finance ( email )

198 Berkeley Street
Carlton VIC 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Bas J.M. Werker

Tilburg University - Center for Economic Research (CentER) ( email )

Econometrics and Finance Group
5000 LE Tilburg
Netherlands

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
168
Abstract Views
952
rank
196,041
PlumX Metrics