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Research丨Xiaoyan Zhang, Xue Wang et al: The International Commonality of Idiosyncratic Variances

Time: 2024-06-14 15:40 Print

The paper titled "The International Commonality of Idiosyncratic Variances," coauthored by Xiaoyan Zhang (Associate Dean and Chair Professor of Finance), Xue Wang (Senior Research Fellow) at PBC School of Finance, Tsinghua University, and Geert Bekaert (Professor at Columbia University), was recently published in the top-tier journal Management Science.

Idiosyncratic return variance, which represents the uncertainty in stock returns not explained by systematic risks, is a crucial indicator for assessing investment risk and has attracted significant attention from academics and industry professionals in recent years. While previous studies have primarily focused on its time-series behavior and its relationship with cross-sectional stock returns, this paper offers a novel perspective. After examining idiosyncratic return variances across 23 developed markets, this study finds that, despite the significant differences among these markets, their idiosyncratic return variances display remarkable commonality, even more pronounced than the commonality in the stock returns themselves. This commonality persists regardless of the specific factor model used to calculate idiosyncratic variance. To ensure robustness, the paper employs six different models to calculate idiosyncratic volatility, with all results consistently demonstrating the prevalence of this commonality.

This paper proposes a dynamic valuation model to explain the global commonality. Comovement in idiosyncratic return variances can arise from the variability of pure idiosyncratic cash flows and any time-varying variability of discount rate and cash flow factors that is not picked up by the factor model to obtain idiosyncratic return variances. To the extent that these variables have an important global component, they may also explain the international commonality in idiosyncratic return variances. The findings of this paper reveal that idiosyncratic cash flow variances exhibit international commonality and are the most significant explanatory factor. Additionally, factors such as the aggregate discount rate, conditional market variance, aggregate cash flow growth and its conditional variance, and a measure of growth opportunities all contribute to explaining the international commonality of stock return idiosyncratic volatility.

Finally, this paper examines the dynamics of the global idiosyncratic return and cash flow variances by focusing on their cyclical properties, and finds them to be mostly but not always countercyclical. The statistical evidence for overall countercyclicality at the global level is strong for cash flow but weaker for return variances. At the country level, there is more uniform evidence in favor of countercyclicality. The finding of idiosyncratic cash flow variances predicting output growth echoes the recent macro literature suggesting a negative link between uncertainty and future economic activity.

About the authors:

Xiaoyan Zhang, Associate Dean, Professor of Finance, Deputy Director of Tsinghua Fintech Research Institute, Director of Xinyuan Fintech Research Center, Director of Research Center for Wealth Management, PBC School of Finance at Tsinghua University.

Xue Wang, Senior Research Fellow of Xinyuan Fintech Research Center, PBC School of Finance, Tsinghua University.

Geert Bekaert, Professor at Columbia Business School, Columbia University.

Contributor 丨Xinyuan Fintech Research Center

Text 丨Xue Wang

Review 丨Xiang Gao