Does Idiosyncratic Volatility Proxy for Risk Exposure?

Abstract

We decompose aggregate market variance into an average correlation component and an average variance component. First, we show that the average variance component commands a negative price of risk in the cross-section of portfolios sorted by idiosyncratic volatility. The average correlation component is not significantly priced. Second, we show that portfolios with high idiosyncratic volatility relative to the Fama-French model have positive exposures to innovations in average stock variance and therefore lower expected returns. On the other hand, portfolios with low idiosyncratic volatility relative to the Fama-French model have negative exposures to innovations in average stock variance and therefore higher expected returns. This difference in the variance loadings between high and low idiosyncratic risk stocks, combined with the negative premium for average stock variance, completely explains the idiosyncratic volatility puzzle of Ang, et al. (2006, 2009). Idiosyncratic risk appears to be related to expected returns because it is a proxy for exposure to average stock variance. We explore a growth options explanation behind our results. Stocks with high idiosyncratic volatility have higher research and development expenditures than stocks with low idiosyncratic volatility, and therefore are likely to have more growth options. This explains the positive relation between high idiosyncratic volatility portfolios and aggregate market variance.