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Idiosyncratic Volatility and the ICAPM Covariance Risk

Published online by Cambridge University Press:  28 March 2025

Bing Han  and
Gang Li Open the ORCID record for Gang Li [Opens in a new window]
Bing Han
Affiliation:
University of Toronto Rotman School of Management and Chinese University of Hong Kong bing.han@rotman.utoronto.ca
Gang Li*
Affiliation:
Chinese University of Hong Kong CUHK Business School
*
gang.li@cuhk.edu.hk (corresponding author)
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Abstract

We show theoretically and empirically that the cross-section of stock return idiosyncratic volatilities contains useful information about the ICAPM. We construct a proxy cross-sectional bivariate idiosyncratic volatility (CBIV) for the covariance risk between the market and the unobserved hedge portfolio under the ICAPM. Consistent with the ICAPM pricing relation, CBIV is a robust and significant predictor of the equity risk premium. We further show that the return predictability of the tail index in Kelly and Jiang (2014) can be explained by the ICAPM covariance risk.

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Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 28
Copyright
© The Author(s), 2025. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We appreciate valuable comments from Hendrik Bessembinder (the editor), Turan Bali, Jay Cao, Kalok Chan, Darwin Choi, Alexandre Corhay, Michael Gallmeyer (the referee), Dashan Huang, Yoontae Jeon, Wenxi Jiang, Raymond Kan, Charles Martineau, Tom McCurdy, Chayawat Ornthanalai, Dave Rapach, Mike Simutin, Jincheng Tong, William Waller, Yizhou Xiao, Nancy Xu, Yanhui Zhao, as well as seminar participants at Beijing Institute of Technology, Cheung Kong Graduate School of Business, Chinese University of Hong Kong (CUHK), CUHK Shenzhen, Dongbei University of Finance and Economics, London School of Economics and Political Science, Shanghai University of Finance and Economics, Southwestern University of Finance and Economics, Tianjin University, University of International Business and Economics, University of South Carolina, University of Sussex, University of Toronto, 2020 APAD, 2020 NFA, 2020 FMA, 2021 Frontiers of Factor Investing, 2021 ITAM, 2021 AsiaFA (2021), and 2021 CIRF for very helpful comments. An earlier version of this article is titled “Idiosyncratic Volatility and the Intertemporal Capital Asset Pricing Model.”

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