Arbitrage Pricing Theory for Idiosyncratic Variance Factors

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.