′Idiosyncratic Volatility Puzzle′
johnright
litlist.pptxSimple, elegant models developed in the 1960s with 2 important assumptions:
Only systematic risk matters, idiosyncratic risk is not priced (Sharpe 1964)
Systematc risk = co-variance with market factor(s) (i.e. β)
Idiosyncratic risk can always be diversified away
Efficient Market Hypothesis (EMH) (Samuelson 1965)
All new information is reflected in prices immediately, entirely and correctly
No arbitrage opportunities, no value to private information
Both assumptions have been questioned early on (Lintner 1965b; Simon 1955). Debate long remained academic only since mainstream models performed well for investors in 20th century
Several related linear factor models
Capital Asset Pricing Model (Sharpe 1964 & Lintner 1965a)
Intertemporal CAPM (Merton 1973)
Arbitrage Pricing Theory (Ross 1976)
3-Factor model (Fama & French 1992)
5-Factor model (Fama & French 2015)
Literature strand 1 – summary Mainstream Asset Valuation
E(return)
E(systematic risk)
price
only systematic risk matters:
market-wide shocks that impact all assets,
cannot be diversified
Literature strand 1 – theoretical lenses Mainstream Asset Valuation
Assumption 1
events
risk
price (immediate)
efficient market hypothesis
new information is reflected in prices immediately, entirely & correctly,
no (info) arbitrage opportunities
Assumption 2
E(return)
E(idiosyncratic risk)
idiosyncratic risk is not priced:
company-specific shocks that impact an individual asset,
diversifiable
E(…) = “expected …”
P(…) = “perceived …”
... = “change in …”
Literature strand 1 – selected readings Mainstream Asset Valuation
Markowitz, H. 1952. Portfolio Selection. Journal of Finance 7.1, 77-91
Simon, HA. 1955. A Behavioral Model of Rational Choice. The Quarterly Journal of Economics 69.1, 99-118
Tobin, J. 1958. Liquidity Preference as Behavior Towards Risk. Review of Economic Studies 25.2, 65-86
Sharpe, WF. 1964. Capital Asset Prices: A Theory of Market equilibrium under Conditions of Risk. Journal of Finance 19.3, 425-442
Lintner, J. 1965a. The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics 47.1 13-37
Lintner, J. 1965b. Security prices, risk and maximal gains from diversification. Journal of Finance 20.6, 587-615
Samuelson, PA. 1965. Proof That Properly Anticipated Prices Fluctuate Randomly. Industrial Management Review 6.2, 41-49
Merton, RC. 1973. An Intertemporal Capital Asset Pricing Model. Econometrica 41.5, 867–887
Ross, SA. 1976. The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory 13, 341-360
Fama, EF & French, KR. 1992. The cross-section of expected stock returns. Journal of Finance 47.2, 427-465
Fama, EF & French, KR. 2015. A five-factor asset pricing model. Journal of Financial Economics 116.1, 1-22
Empirically investors are under-diversified. Given this reality do investors price idiosyncratic risk (IR)? (Lintner 1965)
Renewed interest and scholarly debate since 2000, because
Idiosyncratic volatility** (IV) exhibits a rising trend since 1962 (Campbell et al. 2000)
Idiosyncratic Volatility Puzzle: IV correlates negatively with returns (Ang et al. 2006 & 2009)
Literature mainly debates measurement – i.e. epistemology of IR
From historic averages to forward projections (f.i. (E)GARCH induces positive correlation)
Correcting for time series features (f.i. volatility clustering, return reversals)
Other scholars question the meaning of IV – i.e. ontology of IR
Does IV measure IR or not? Main alternative hypothesis: IV reflects company transparency & news flow (Ferreira & Laux 2007, Jiang et al. 2009, Lee & Liu 2011, Hou & Loh 2016)
Inherent reflexivity in price based measures induces circularity: price setting determines idiosyncratic risk & idiosyncratic risk determines price setting
Literature strand 2 – summary Idiosyncratic Risk in Cross-Section of Returns*
* see also literature strands 2‘ and 2‘‘ in appendix
** i.e. excess volatility observed over and above the part that can be explained by mainstream models
idio. risk
idio. volatility
events
E(idio. risk)
=
E(return)
+
+
by definition
efficient market
-
PUZZLE
+
E’(idio. risk)
~
E(return)
behavioral:
lottery preferences, skewness,
option value (leveraged)
market micro-structure:
autocorrelation,
return reversal,
volatility clustering
ontology of volatility: volatility = f(news flow),
news flow = f(transparency)
… and its reverse (!):
volatility = f(trading),
trading = f(uncertainty),
uncertainty = f(transparency)
+
+
+
trading
uncertainty
-
idio. risk
idio. volatility
events
+
news flow
+
+
E(return)
-
transparency
+
Literature strand 2 – it’s a puzzle Idiosyncratic Risk in Cross-Section of Returns
models of reality
potential explanations
E(…) = “expected …”
P(…) = “perceived …”
... = “change in …”
Conundrum: pricing (volatility) no longer unbiased measure of E(risk)
E(risk)
?
Consequence: efficient market hypothesis no longer supported …
Lintner, J. 1965. Security prices, risk and maximal gains from diversification. Journal of Finance 20.6, 587-615
Fama, EF & MacBeth, JD. 1973. Risk, Return, and Equilibrium: Empirical Tests. Journal of Political Economy 81.3, 607-636
Levy, H. 1978. Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio. American Economic Review 68.4, 643-658
Merton, RC. 1987. A simple Model of Capital Market Equilibrium with Incomplete Information. Journal of Finance 42.3, 483-510
Lehman, B. 1990. Residual risk revisited. Journal of Econometrics 45, 71-97
Campbell, JY, Lettau, M, Malkiel, BG & Xu, Y. 2001. Have Individual Stocks Become More Volatile? An empirical exploration of Idiosyncratic Risk. Journal of Finance 56, 1-43
Malkiel, BG & Xu, Y. 2004. Idiosyncratic Risk and Security Returns. In AFA 2001 New Orleans Meetings
Spiegel, MI & Wang, X. 2005. Cross-Sectional Variation in Stock Returns: Liquidity and Idiosyncratic Risk. Yale ICF Working Paper No. 05-13, EFA 2005 Moscow Meetings Paper
Ang, A, Hodrick, RJ, Xing, Y & Zang, X. 2006. The Cross-Section of Volatility and Expected Returns. Journal of Finance 61.1, 259-299
Ferreira, MA & Laux, PA. 2007. Corporate Governance, Idiosyncratic Risk, and Information Flow. Journal of Finance 62.2, 951-989
Bali, TG & Cakici, N. 2008. Idiosyncratic Volatility and the Cross-Section of Expected Returns. Journal of Financial and Quantitative Analysis 43.1, 29-58
Ang, A, Hodrick, RJ, Xing, Y & Zang, X. 2009. High idiosyncratic risk and low returns: international and further US evidence. Journal of Financial Economics 91, 1-23
Brockman, P, Vivero, MG & Yu, W. 2009. Is idiosyncratic volatility priced? The International evidence. Available at SSRN: https://ssrn.com/abstract=1364530
Fu, F. 2009. Idiosyncratic risk and the cross-section of expected stock returns. Journal of Financial Economics 91, 24-37
Jiang, GJ, Xu, D & Yao, T. 2009. The information Content of Idiosyncratic Volatility. Journal of Financial and quantitative analysis 44.1, 1-28
Huang, W, Liu, Q, Rhee, SG & Zhang, L. 2010. Return Reversals, Idiosyncratic Risk and Expected Returns. Review of Financial studies 23, 147-168
Lee, DW & Liu, MH. 2011. Does more information in stock price lead to greater or smaller idiosyncratic return volatility? Journal of Banking & Finance 35, 1563-1580
Eiling, E. 2013. Industry-Specific Human Capital, Idiosyncratic Risk, and the Cross-Section of Expected Stock Returns. Journal of Finance. 68.1, 43-48
Hou, K & Loh, RK. 2016. Have we solved the idiosyncratic volatility puzzle? Journal of financial economics 121, 167-194
Literature strand 2 – selected readings Idiosyncratic Risk in Cross-Section of Returns
