2012, “Does Idiosyncratic Volatility Proxy for Risk Exposure

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. (JEL G12) In an influential study, Ang, Hodrick, Xing, and Zhang (2006, 2009; AHXZ hereafter) show that stocks with high idiosyncratic risk, defined as the standard deviation of the residuals from the Fama-French (1993) model, have anomalously low future returns.1 This finding is puzzling in light of theories that suggest that idiosyncratic volatility (denoted as IV) should be irrelevant or positively related to expected returns.2 If a factor is missing from the Fama-French model, the sensitivity of stocks to the missing factor times the movement in the missing factor will show up in the residuals of the model. Firms with greater sensitivities to the missing factor We thank Geert Bekaert (editor), two anonymous referees, and seminar participants at the Norwegian Business School (BI) and Texas A&M University for many valuable comments and suggestions. Chen acknowledges financial support from a Nanyang Technological University Start-up Grant. Send correspondence to Ralits