A Model-Free Measure of Aggregate Idiosyncratic Volatility and the Prediction of Market Returns. (27th August 2014)

• Record Type: Journal Article
• Is Part Of: Journal of financial and quantitative analysis. Volume 49:Number 5/6(2015)
• Page Start: 1133
• Page End: 1165
• Publication Date: 2014-08-27
• Subjects: Finance -- Periodicals; Investments -- Mathematics -- Periodicals; 332.05
• DOI: 10.1017/S0022109014000489
• Languages: English
• ISSNs: 0022-1090

Abstract

Abstract: In this paper, we formally show that the cross-sectional variance of stock returns is a consistent and asymptotically efficient estimator for aggregate idiosyncratic volatility. This measure has two key advantages: It is model free and observable at any frequency. Previous approaches have used monthly model-based measures constructed from time series of daily returns. The newly proposed cross-sectional volatility measure is a strong predictor for future returns on the aggregate stock market at the daily frequency. Using the cross section of size and book-to-market portfolios, we show that the portfolios' exposures to the aggregate idiosyncratic volatility risk predict the cross section of expected returns.