A Multi-Factor Model of Idiosyncratic Volatility
59 Pages Posted: 30 Jul 2018 Last revised: 1 Aug 2019
Date Written: July 31, 2019
Time-varying leverage driven by common shocks to firm asset returns introduces a factor structure in idiosyncratic equity return volatilities (IVOL). In a standard dynamic capital structure model in which the CAPM holds for asset returns we show that three factors explain the IVOL cross-section: the average IVOL to capture market-wide leverage dynamics, and two size and leverage-driven factors to capture the time-varying dispersion. The negative return-IVOL relation is driven with the leverage-induced common component of IVOL; the Merton (1987) positive relation is recovered for the part of IVOL that is not explained by (financial) leverage.
Keywords: Idiosyncratic Volatility, Volatility Co-movement, Risk Factors, Leverage, Capital Structure
JEL Classification: G12, G32, C15
Suggested Citation: Suggested Citation