Idiosyncratic Volatility and the Intertemporal Capital Asset Pricing Model

Abstract

We show that the average stock return idiosyncratic volatility contains useful information about the covariance between the market and hedge portfolio under the ICAPM. Two different weighted averages of individual stock idiosyncratic volatility together can significantly predict stock market returns over both short- and long-term horizons, both in sample and out of sample. We propose a new method to estimate individual stock exposure to the unobserved hedge portfolio using aggregate idiosyncratic risk measures and find that the estimated beta is significantly related to the cross-section of expected stock returns. Finally, we show both theoretically and empirically that the return predictability of the tail index in Kelly and Jiang (2014) can be explained under the ICAPM. Our results support the ICAPM pricing relationship both in the time series and cross-section of stock returns.

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

JEL Classification: G12, G13, G14, G17