A Multi-Factor Model of Idiosyncratic Volatility

91 Pages Posted: 30 Jul 2018 Last revised: 6 Aug 2020

See all articles by Thijs van der Heijden

Thijs van der Heijden

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

Qi Zeng

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

Yichao Zhu

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics

Date Written: August 5, 2020

Abstract

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 mainly captures market-wide leverage dynamics, and a size factor and a leverage-driven factor account for the time-varying dispersion. Just like equity IVOL, debt return IVOL shows a strong factor structure and the two are strongly correlated. Our findings also shed light on the negative IVOL-return puzzle and the time-series pattern of average IVOL.

Keywords: Idiosyncratic Volatility, Volatility Co-movement, Risk Factors, Leverage, Capital Structure

JEL Classification: G12, G32, C15

Suggested Citation

van der Heijden, Thijs and Zeng, Qi and Zhu, Yichao, A Multi-Factor Model of Idiosyncratic Volatility (August 5, 2020). 31st Australasian Finance and Banking Conference 2018, Available at SSRN: https://ssrn.com/abstract=3221878 or http://dx.doi.org/10.2139/ssrn.3221878

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

Qi Zeng

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 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

Yichao Zhu

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Applied Statistics ( email )

Kingsley Street
acton, ACT 0200
Australia

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