Arbitrage pricing theory for idiosyncratic variance factors
Renault,Eric Van der Heijden,Thijs Werker,Bas J. M.
Renault,Eric
Van der Heijden,Thijs
Werker,Bas J. M.
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.
Description
We thank conference participants at the Econometrics of High-Dimensional Risk Networks at the Stefanovich Center, the Sofie 2016 conference, the Vienna–Copenhagen 2017 conference, the Australian Finance and Banking Conference 2018, seminar participants at Tilburg University and the University of Lugano, and Jonathan Dark, Rob Engle, Dacheng Xiu, and Chu Zhang for helpful comments and suggestions. Two referees and the editor provided valuable comments to improve the paper as well.
Date
2023-11
Journal Title
Journal ISSN
Volume Title
Publisher
Research Projects
Organizational Units
Journal Issue
Keywords
Arbitrage pricing theory, Common volatility factors, Nonlinear pricing kernels, Option prices
Citation
Renault, E, Van der Heijden, T & Werker, B J M 2023, 'Arbitrage pricing theory for idiosyncratic variance factors', Journal of Financial Econometrics, vol. 21, no. 5, pp. 1403-1442. https://doi.org/10.1093/jjfinec/nbac008
License
info:eu-repo/semantics/openAccess