Idiosyncratic Volatility and the Intertemporal Capital Asset Pricing Model
70 Pages Posted: 17 Nov 2019 Last revised: 5 Jan 2020
Date Written: October 30, 2019
When the true asset pricing model cannot be identified, the idiosyncratic volatility obtained from a misspecified model contains information of the hedge portfolio in Merton’s (1973) ICAPM. Empirically, I find that from 1815 to 2018, more than two centuries, neither equal-weighted idiosyncratic volatility (EWIV) nor value-weighted idiosyncratic volatility (VWIV) can forecast stock market returns. However, EWIV and VWIV when applied together are strong predictors of stock market returns over short- and long-term horizons. The explanatory power is economically significant with an out-of-sample forecasting r-squared around 1% for one month and 12% for one year. This finding suggests that EWIV and VWIV together are linked to state variables that capture time-varying investment opportunities. Furthermore, EWIV and VWIV jointly can explain the cross-section of average stock returns with a beta quintile spread of 7.88% per year. I argue that the combination of EWIV and VWIV is a proxy for the conditional covariance risk in the ICAPM. I revisit the debate between Goyal and Santa-Clara (2003) and Bali, Cakici, Yan, and Zhang (2005) and reconcile their mixed findings between the idiosyncratic volatility and future stock market returns. Finally, this paper also gives new insights for the tail risk measure proposed by Kelly and Jiang (2014).
Keywords: idiosyncratic volatility, stock market variance, conditional covariance, time-series stock return predictability, cross-section of stock returns, expected stock returns, intertemporal capital asset pricing model, economic state variable, risk-return tradeoff
JEL Classification: G12, G13, G14, G17
Suggested Citation: Suggested Citation