Idiosyncratic Cross-Section Volatility and Market Volatility

Category: Finance Brown Bag Seminar
When: 07 June 2017
, 02:00
 - 03:00
Where: HoF E.20
Speaker: Jun Li

Authors: Jun Li (Goethe University)


Idiosyncratic Cross-Section Volatility and Market Volatility

Abstract: Idiosyncratic cross-section volatility (ICSV), defined as the cross-section volatility of idiosyncratic component of individual stock returns, has negligible correlation with market return, but it spikes when the market volatility, credit spread and default probability are high. To understand the empirical facts, this paper develops a general equilibrium model in which the default risks arise when ICSV is high, both creditor and borrower are afraid of default risks, therefore both credit supply and demand drop. Default risks also affect future market return since creditor and borrower demand higher future returns when default risks are high. The model endogenously generates strong correlation between ICSV and market volatility. It also implies that default risks measure should positively predict future returns. The model replicates well the increase in market volatility and default risks during financial crisis.