The Common and Specific Components of Dynamic Volatility

Northwestern University, Finance Working Paper No. 311

32 Pages Posted: 3 Nov 2002  

Gregory Connor

London School of Economics & Political Science (LSE) - Department of Accounting and Finance

Robert A. Korajczyk

Northwestern University - Kellogg School of Management

Oliver B. Linton

University of Cambridge

Multiple version iconThere are 2 versions of this paper

Date Written: July 24, 2003

Abstract

This paper develops a dynamic approximate factor model in which returns are time-series heteroskedastic. The heteroskedasticity has three components: a factor-related component, a common asset-specific component, and a purely asset-specific component. We develop a new multivariate GARCH model for the factor-related component. We develop a univariate stochastic volatility model linked to a cross-sectional series of individual GARCH models for the common asset-specific component and the purely asset-specific component. We apply the analysis to monthly US equity returns for the period January 1926 to December 2000. We find that all three components contribute to the heteroskedasticity of individual equity returns. Factor volatility and the common component in asset-specific volatility have long-term secular trends as well as short-term autocorrelation. Factor volatility has correlation with interest rates and the business cycle.

Keywords: APT, ARCH, Factor Models, Principal Components, Volatility

JEL Classification: C13, C23, G12

Suggested Citation

Connor, Gregory and Korajczyk, Robert A. and Linton, Oliver B., The Common and Specific Components of Dynamic Volatility (July 24, 2003). Northwestern University, Finance Working Paper No. 311. Available at SSRN: https://ssrn.com/abstract=334040 or http://dx.doi.org/10.2139/ssrn.334040

Gregory Connor (Contact Author)

London School of Economics & Political Science (LSE) - Department of Accounting and Finance ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 702 955-6407 (Phone)
+44 702 955-7420 (Fax)

Robert A. Korajczyk

Northwestern University - Kellogg School of Management ( email )

Kellogg School of Management
2211 Campus Drive, Room 4357
Evanston, IL 60208
United States
847-491-8336 (Phone)
847-491-5719 (Fax)

HOME PAGE: http://www.kellogg.northwestern.edu/faculty/directory/korajczyk_robert.aspx#research

Oliver B. Linton

University of Cambridge ( email )

Faculty of Economics
Cambridge, CB3 9DD
United Kingdom

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