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The relation between time-series and cross-sectional effects of idiosyncratic variance on stock returns in G7 countries

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Hui Guo
Robert Savickas

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Abstract

This paper suggests that CAPM-based idiosyncratic variance (IV) correlates negatively with future stock returns because it is a proxy for loadings on discount-rate shocks in Campbell*s (1993) ICAPM. The ICAPM also implies that there are important links between the time-series and cross-sectional IV effects. For example, the coefficients on conditional stock market variance and value-weighted average IV obtained from the time-series regressions reflect loadings on stock market returns and discount-rate shocks, respectively; therefore, they should help explain the cross section of stock returns. Moreover, we expect a close relation between the IV and book-to-market effects because recent studies show that the latter also reflects intertemporal pricing. These conjectures are strongly supported by the G7 countries* data.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2006-036.

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Date of creation: 2006
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Handle: RePEc:fip:fedlwp:2006-036

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