Does Idiosyncratic Volatility Proxy for Risk Exposure?

Abstract

We decompose aggregate market variance into an average correlation component and an average variance component. Only the latter commands a negative price of risk in the cross section of portfolios sorted by idiosyncratic volatility. Portfolios with high (low) idiosyncratic volatility relative to the Fama-French ( 1993 ) model have positive (negative) exposures to innovations in average stock variance and therefore lower (higher) expected returns. These two findings explain the idiosyncratic volatility puzzle of Ang et al. ( 2006 , 2009 ). The factor related to innovations in average variance also reduces the pricing errors of book-to-market and momentum portfolios relative to the Fama-French ( 1993 ) model.