Working Paper: NBER ID: w20076
Authors: Bernard Herskovic; Bryan T. Kelly; Hanno Lustig; Stijn Van Nieuwerburgh
Abstract: We show that firms’ idiosyncratic volatility obeys a strong factor structure and that shocks to the common factor in idiosyncratic volatility (CIV) are priced. Stocks in the lowest CIV-beta quintile earn average returns 5.4% per year higher than those in the highest quintile. The CIV factor helps to explain a number of asset pricing anomalies. We provide new evidence linking the CIV factor to income risk faced by households. These three facts are consistent with an incomplete markets heterogeneous-agent model. In the model, CIV is a priced state variable because an increase in idiosyncratic firm volatility raises the average household’s marginal utility. The calibrated model matches the high degree of comovement in idiosyncratic volatilities, the CIV-beta return spread, and several other asset price moments.
Keywords: idiosyncratic volatility; asset pricing; household income risk
JEL Codes: E44; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| common idiosyncratic volatility (CIV) (G19) | household's marginal utility (D11) |
| common idiosyncratic volatility (CIV) (G19) | household income risk (G59) |
| common idiosyncratic volatility (CIV) (G19) | asset prices (G19) |
| idiosyncratic firm volatility (D25) | household consumption risk (D11) |
| idiosyncratic firm volatility (D25) | marginal utility (D11) |
| CIV shocks (E32) | expected stock returns (G17) |
| differences in firms' betas on CIV shocks (C46) | differences in expected returns (G19) |