Average Idiosyncratic Volatility in G7 Countries

We argue that changes in average idiosyncratic volatility provide a proxy for changes in the investment opportunity set and that this proxy is closely related to the book-to-market factor. We test this idea in two ways using G7 countries’ data. First, we show that idiosyncratic volatility has statistically significant predictive power for aggregate stock market returns over time. Second, we show that idiosyncratic volatility performs just as well as the book-to-market factor in explaining the cross section of stock returns. Our results suggest that the hedge against changes in investment opportunities is an important determinant of asset prices.