Arbitrage Pricing Theory for Idiosyncratic Variance Factors

Author:

Renault Eric12,Van Der Heijden Thijs3,Werker Bas J M4ORCID

Affiliation:

1. Department of Economics, University of Warwick, Coventry CV4 7AL, UK

2. Department of Econometrics, Monash University, Wellington Road, Clayton, VIC 3800, Australia

3. Department of Finance, The University of Melbourne, 198 Berkeley Street, Carlton, VIC 3010, Australia

4. Econometrics and Finance Group, Netspar, Tilburg University, P.O. Box 90153, 5000 LE, Tilburg, The Netherlands

Abstract

Abstract We develop an arbitrage pricing theory framework extension to study the pricing of squared returns/volatilities. We analyze the interplay between factors at the return level and those in idiosyncratic variances. We confirm the presence of a common idiosyncratic variance factor, but do not find evidence that this represents a missing risk factor at the (linear) return level. Thereby, we consistently identify idiosyncratic returns. The price of the idiosyncratic variance factor identified by squared returns is small relative to the price of market variance risk. The quadratic pricing kernels induced by our model are in line with standard economic intuition.

Publisher

Oxford University Press (OUP)

Subject

Economics and Econometrics,Finance

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