Idiosyncratic Volatility and the ICAPM Covariance Risk

Abstract

We show theoretically and empirically that the cross-section of stock return idiosyncratic volatilities contains useful information about the ICAPM. We construct a proxy (CBIV) for the covariance risk between the market and the unobserved hedge portfolio under the ICAPM. Consistent with the ICAPM pricing relation, CBIV is a robust and significant predictor of the equity risk premium. We further show that the return predictability of the tail index in Kelly and Jiang (2014) can be explained by the ICAPM covariance risk.

Keywords: idiosyncratic volatility, conditional covariance risk, tail risk, time-series return predictability, intertemporal capital asset pricing model

JEL Classification: G12, G13, G14, G17