A Multi-Factor Model of Idiosyncratic Volatility

Time-varying leverage driven by common shocks to firm asset returns introduces a factor structure in idiosyncratic equity return volatilities (IVOL). In a standard dynamic capital structure model in which the CAPM holds for asset returns, we show that three factors explain the IVOL cross-section: the average IVOL mainly captures market-wide leverage dynamics, and a size factor and a leverage-driven factor account for the time-varying dispersion. Just like equity IVOL, debt return IVOL shows a strong factor structure and the two are strongly correlated. Our findings also shed light on the negative IVOL-return puzzle and the time-series pattern of average IVOL