Idiosyncratic volatility factor and macroeconomic risks
(with Yangming BAO)
Recent literature has documented a high degree of commonality among idiosyncratic volatilities (IVol) of stock returns and its theoretical link to macroeconomic risks. This paper proposes an econometric framework that can extract the latent factor among IVol, which we term the idiosyncratic volatility factor (IVF). We show its superb asset pricing ability and negative price of risk as predicted by theory. We also find a strong positive relation between IVF and macroeconomic uncertainty. Using a fractionally cointegrated VAR model, we further uncover its long-run equilibrium relation with the market volatility as well as the impact of disequilibrium on macroeconomic uncertainty.