Idiosyncratic Volatility and the Intertemporal Capital Asset Pricing Model

Proceedings of ‏The 10th International Conference on Modern Research in Management, Economics and Accounting

Year: 2020

DOI:

Fulltex PDF

Idiosyncratic Volatility and the Intertemporal Capital Asset Pricing Model

Gang Li

ABSTRACT: 

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 𝑅2 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. 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 aggregate idiosyncratic volatility and future stock market returns.

Keywords: idiosyncratic volatility, stock market variance, conditional covariance, time-series stock return predictability, expected stock returns, intertemporal capital asset pricing model,economic state variable, risk-return tradeoff.