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Arbitrage Pricing Theory for Idiosyncratic Variance Factors

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  • Eric Renault
  • Thijs Van Der
  • Bas J M Werker

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.

Suggested Citation

  • Eric Renault & Thijs Van Der & Bas J M Werker, 2023. "Arbitrage Pricing Theory for Idiosyncratic Variance Factors," Journal of Financial Econometrics, Oxford University Press, vol. 21(5), pages 1403-1442.
    • Handle: RePEc:oup:jfinec:v:21:y:2023:i:5:p:1403-1442.
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    More about this item

    Keywords

    arbitrage pricing theory; common volatility factors; nonlinear pricing kernels; option prices;
    All these keywords.

    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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