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Idiosyncratic Volatility Covariance and Expected Stock Returns
Author(s) -
Peterson David R.,
Smedema Adam R.
Publication year - 2013
Publication title -
financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.647
H-Index - 68
eISSN - 1755-053X
pISSN - 0046-3892
DOI - 10.1111/fima.12019
Subject(s) - volatility (finance) , economics , stock (firearms) , portfolio , econometrics , financial economics , volatility risk premium , systematic risk , covariance , stock market , monetary economics , implied volatility , mathematics , statistics , biology , mechanical engineering , paleontology , horse , engineering
Given that the idiosyncratic volatility (IDVOL) of individual stocks co‐varies, we develop a model to determine how aggregate idiosyncratic volatility (AIV) may affect the volatility of a portfolio with a finite number of stocks. In portfolio and cross‐sectional tests, we find that stocks whose returns are more correlated with AIV innovations have lower returns than those that are less correlated with AIV innovations. These results are robust to controlling for the stock's own IDVOL and market volatility. We conclude that risk‐averse investors pay a premium for stocks that pay well when AIV is high, consistent with our model.