Proceedings of The 7th International Conference on New Ideas in Management, Economics and Accounting
Year: 2020
DOI: https://www.doi.org/10.33422/10th.mea.2020.03.56
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 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: G12, G13, G14, G17.