Research Division

Federal Reserve Bank of St. Louis Working Paper Series

Understanding Stock Return Predictability

Hui Guo and Robert Savickas

Working Paper 2006-019B http://research.stlouisfed.org/wp/2006/2006-019.pdf

March 2006 Revised October 2006

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Understanding Stock Return Predictability
Hui Guo
*

Robert Savickas George Washington University

Federal Reserve Bank of St. Louis

This Version: September 27, 2006

*

Mailing Addresses: Research Division, the Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis,

MO 63166-0442, E-mail: hui.guo@stls.frb.org (Hui Guo, corresponding author); Department of Finance, George Washington University, 2023 G Street, N.W., Washington, DC 20052, E-mail: Savickas@gwu.edu (Robert Savickas). We thank Yakov Amihud, Torben Andersen, Andrew Ang, John Campbell, Samuel Thompson, Tuomo Vuolteenaho, and Lu Zhang for comments and suggestions. We also thank Amit Goyal for making his data available to us through his webpage. The views expressed in this paper are those of the authors and do not necessarily reflect the official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Understanding Stock Return Predictability
Abstract Over the period 1927:Q1 to 2005:Q4, the average CAPM-based idiosyncratic variance (IV) and stock market variance jointly forecast stock market returns. This result holds up quite well in a number of robustness checks, and we show that the predictive power of the average IV might come from its close relation with systematic risk omitted from CAPM. First, high lagged returns on high IV stocks predict low future returns on the market as a whole. Second, returns on a hedging portfolio that is long in stocks with low IV and short in stocks with high IV perform as well as the value premium in explaining the cross-section of stock returns. Third, realized variance of the hedging portfolio or of the value premium is closely correlated with the average IV, and these variables have similar predictive power for stock returns. Keywords: Stock Return Predictability, Average Idiosyncratic Variance, Stock Market Variance, Discount-Rate Shock, Cash-Flow Shock, CAPM, and ICAPM. JEF number: G1.

Merton does not explicitly specify the state variables that describe investment opportunities. especially in the out-of-sample context. Cochrane (2006) points out that because dividend growth has negligible predictable variation and the dividend yield is quite volatile. Lewellen (2004). Baker and Wurgler (2000). However. Campbell and Cochrane (1999) and others have also developed rational expectations models to explain the observed stock return predictability. and Lettau and Nieuwerburgh (2006). Introduction There is an ongoing debate about whether the equity premium is predictable or not.. and show quite convincingly that there is little support for stock return predictability.g. Pontiff and Schall (1998). the dividend yield must forecast stock market returns. some recent studies. Campbell and Thompson (2005). In the empirical analysis. In this paper.. the out-of-sample test based on the linear specification has low power to detect stock return predictability. The variables used in the early studies have poor out-of-sample forecasting power possibly because they are not direct measures of the conditional equity premium. Goyal and Welch (2006) have conducted a comprehensive examination of the existing evidence using the data updated to 2004. we use the risk factors that appear to perform well in explaining the cross-section of 1 . Cochrane also provides simulation results to show that for the size of samples commonly used in the empirical studies. Early authors—e. and Lettau and Ludvigson (2001)—find that some financial variables have significant forecasting power for excess stock market returns. e. Moreover. have documented some out-of-sample predictability by using alternative forecasting specifications. we propose a couple of predictive variables following the intuition of Merton’s (1973) ICAPM.1. Fama and French (1989). which stipulates that the conditional equity premium is a linear function of its (1) conditional variance and (2) conditional covariance with shocks to investment opportunities. Kothari and Shanken (1997). Keim and Stambaugh (1986). Campbell (1987). Campbell and Shiller (1988).g.

t is the shock to the hedging factor. imposing the ICAPM restriction makes our specification less vulnerable to data mining. we also find qualitatively similar results using monthly options-implied variances. the CAPM-based IV of stock i has two components: (1) 2 IVi .. we hypothesize that the CAPM-based idiosyncratic variance (IV) is a proxy for investment opportunities and thus forecasts stock returns. 1 2 .stock returns as a proxy for the state variables. Fama and French (1996) suggest that it is a proxy for shocks to investment opportunities. Nevertheless. we mainly focus on quarterly data instead of monthly data because Ghysels et al. where βi . Campbell and Vuolteenaho (2004). Petkova and Zhang (2005). Ang and Chen (2005).t is the true idiosyncratic shock. Campbell (1993) interprets ε DR . show that it is a poor proxy for systematic risk in the pre-1963 sample. ε DR . Thus. and Fama and French (2005). (2004). and Brennan et al. (2005) argue that realized variance is a function of long distributed lags of daily returns. although it cannot be ruled out completely. Fama (1991) has emphasized the importance of establishing a link between the time-series and cross-sectional stock return predictability. Consistent with the ICAPM interpretation.g. which are arguably better measures of conditional variances than realized variances.t + ε i2. and has been commonly used in the asset pricing literature. DR is the loading on the hedging factor. we also find that realized variances of stock market returns and the value premium jointly forecast excess stock market returns over the period 1963:Q4 to 2005:Q4. Petkova (2006). Alternatively. e. Campbell and Vuolteenaho (2004).t = β i2DRε DR . using the value premium as a risk factor has an important limitation because recent studies. in a two-factor ICAPM. and ε i .t as the shock to discount rates because in his model the time-varying equity premium is the main driver of changes in In this paper. Appendix A shows that. .1 However. and Hahn and Lee (2006) provide some support for this conjecture. The value premium is perhaps one of the most successful empirical hedging risk factors.t .

the forecasting power of these variables has been challenged (e. and high volatility of profitability. and Hahn and Lee (2006). the average IV and realized value premium variance are closely correlated with each other and have very similar forecasting power for stock returns. Fama and French (1996) suggest that the value premium is a hedging risk factor because it reflects the distress risk. However. β i . Chen and Zhao (2006)). Indeed. and then show that it performs quite well in explaining both the time-series and cross-sectional stock return predictability. Therefore. we provide out-of-sample tests for Guo and Savickas’ results by Campbell’s (1993) model provides a mechanical link between the time-series and cross-sectional predictability without explaining where stock return predictability is coming from. ICAPM suggests that one can test Fama and French’s conjecture by showing that. These stocks are likely to have long durations and thus are sensitive to the discount-rate shock. as we find in this paper. so have the empirical ICAPM specifications (e. a subset of the commonly used stock return predictors serves as the state variables that describe investment opportunities. These authors also show that stocks with high durations have higher return volatility than stocks with low durations. β i2DRε DR . e. 3 See Lettau and Wachter (2006). Brennan et al. and pay no dividends. have high book-to-market ratio. We first construct a hedging risk factor from the cross-section of stock returns following the ICAPM intuition.3 We investigate the ICAPM implications of time-series stock return predictability in three ways.. Also. Campbell and Vuolteenaho (2004).investment opportunities.. related to a stock’s sensitive to the discount rate shock. Guo and Savickas (2006) show that over the period 1963:Q4 to 2002:Q4. Our approach is different from those used in the early studies. Second. the value premium explains the time-series stock return predictability as well. 2 3 . Pastor and Veronesi (2003). for example. for a formal treatment on the positive relation between durations and sensitivity to discount rate shocks. Campbell’s model appears to provide a sensible theoretical guidance for the empirical analysis in this paper because our main issue is stock returns predictability. First. For example. the economic underpinning of timevarying investment opportunities is an empirical issue. One possible explanation is that the cross-sectional average of the second component in equation (1) is relatively stable over time and the average IV move closely along with the variance of the discount rate shock. Therefore.g.2 We argue that stocks with high IV are more sensitive to the discount-rate shock than are stocks with low IV for two reasons. Goyal and Welch (2006)). over the period 1963:Q4 to 2005:Q4. the valueweighted average IV forecasts stock returns when combined with realized stock market variance. because an increase in the discount rate always leads an immediate 2 fall in stock prices.g.. low returns on equity.g. DR must be negative in equation (1). (2004). recent studies. In the early empirical studies of ICAPM.g. show that high IV stocks tend to be young and small. First. e.t is positively . Petkova (2006)..

Also. we construct a hedging portfolio that is long in stocks with low IV and short in stocks with high IV. (2003)). By establishing a 4 We thank John Campbell for the suggestion of testing this ICAPM implication.4 To address this issue. Second. Data mining is always a concern in the empirical investigation of stock return predictability (e. we find that lagged IVF is positively correlated with future stock market returns. we conduct a number of robustness checks and find that our main findings hold up rather well. high lagged returns on stocks with high IV predict low future returns on the market as a whole because a positive shock to the discount rate leads stock prices to fall initially and to rise subsequently. realized variance of IVF is closely correlated with the average IV and realized value premium variance. and these three variables have qualitatively similar forecasting power for stock returns. Moreover. the predictive power is negligible for lagged returns on low IV stocks. if IV is a proxy for loadings on the discount-rate shock. As conjectured.showing that the average IV forecasts stock returns in a new subsample spanning the period 1927:Q1 to 1963:Q4 as well as in the longer sample spanning the period 1927:Q1 to 2005:Q4. as mentioned above. Ferson et al.g. 4 . By contrast. The maintained hypothesis is that the portfolio return—dubbed as IVF—is a proxy for the discount-rate shock. Moreover. the relation is found to be negative and statistically significant. we follow Eleswarapu and Reinganum (2004) and use the returns on high IV stocks in the previous 12 quarters to forecast excess stock market returns in the following four quarters. Third. Consistent with this conjecture.. is arguably a proxy for systematic risk—in explaining the cross-section of stock returns. realized variances of stock market returns and IVF jointly have significant predictive power for excess stock market returns over the period 1927:Q1 to 2005:Q4. To address this issue. IVF performs as well as or somewhat better than the value premium—which.

DR . DR . σ M . there are two types of shocks to stock market returns—the shock to expected future cash flows and the shock to expected future stock market returns.t : (2) 2 E t ( RM . σ M .t . we briefly explain that stock return predictability is an important implication of ICAPM.t +1 . The remainder of the paper is organized as follows. E t ( RM . For example.t +1 ) − rf . in Campbell’s model. Theoretical Motivations In this section.t = β M .t + (γ − 1)σ M . where γ is a measure of relative risk aversion. As a result. and its conditional covariance with the discount-rate shock.. an increase in expected future stock returns. 2 is a linear function of its conditional variance. 2.t +1 = γσ M . We investigate the predictive power of the average IV in Section 4 and test the hypothesis that IV is a proxy for systematic risk in Section 5.t +1 ) − rf . we can rewrite equation (2) as 5 .t is the loading of stock market returns on the discount-rate shock.e. this evidence suggests that data mining is unlikely the main driver of our results. DR . Campbell (1993) shows that the conditional excess stock market return. DR .t .t . However. the positive discountrate shock is less risky than the negative cash-flow shock because the former also implies an improvement in investment opportunities—i. Section 6 offers some concluding remarks.link between the time-series and cross-sectional stock return predictability.tσ DR . as stressed by Merton (1973) and Campbell (1993). DR . where β M . Section 2 provides some theoretical motivations and Section 3 discusses the data. 2 Using the relation σ M . Stock prices fall if there is a negative cash-flow shock or a positive discount-rate shock.

Also. Therefore. For simplicity. Petkova (2006). if γ is greater than 1. We primarily use the variance of the hedging risk factor (as in equation (3)) instead of the covariance between the hedging risk factor and the excess stock market return (as in equation (2)) to forecast stock returns. This is mainly because we interpret the average IV as a proxy for the variance of the hedging risk factor. 5 6 . is positive if investors are risk averse. the coefficient of 2 σ DR .t .t should be negative. Table 1 shows that realized value premium variance (V_HML) is negatively related to one-quarter-ahead excess stock return returns. DR is negative because an increase in expected stock market returns leads to an immediate fall in stock prices and thus a negative stock market return. although the relation is statistically insignificant. the results for the covariance are not reported here but are available on request. we find qualitatively similar results by using both specifications. Campbell and Vuolteenaho (2004). The coefficient with stock market variance. the second right-hand-side term has a negative coefficient because it serves as a correction for the overpricing of the discount-rate shock in CAPM. we construct realized value premium variance using daily data obtained from Ken French at Dartmouth College for the period 1963:Q3 to 2005:Q4. it is overpriced in the first right-handside term of equation (3). That is. Because the discount-rate shock is not as risky as the cash-flow shock.t + (γ − 1) β M . We also construct realized stock market variance using the daily data obtained from CRSP (Center for Research in Security Prices) database. find that over the post-1963 sample. Recent studies.. when using the value premium or IVF as a proxy for the hedging risk factor.t is conditional variance of the discount-rate shock. The latter result has an intuitive interpretation. the stock market serves as a hedge for changes in investment opportunities. we assume that β M . the value premium is a proxy for shocks to investment opportunities. in Campbell’s (1993) ICAPM. Nevertheless. Brennan et al. DRσ DR .(3) 2 2 E t ( RM .g. as we find in this paper. For brevity. e.5 Note that β M . DR . Stock market variance includes variances of both the discount-rate shock and the cash-flow shock. To investigate this possibility. (2004).t +1 ) − rf . and Hahn and Lee (2006).t +1 = γσ M . in equation (3). 2 where σ DR . γ .t is constant across time.

with a correlation coefficient of about 88%. so does the average IV. Therefore. the value-weighted average IV constructed from the 100 largest stocks (thin line) move closely with realized value premium variance (thick line). This result suggests that the two variables contain similar information about future stock prices.t ⎦ Table B1 in Appendix B shows that the log dividend yield is indeed significantly related to stock market variance and proxies for the variance of the discount-rate shock. when combined with realized stock market variance (MV).Interestingly. Overall. 2 ⎣ ⎦ ⎣σ DR . Moreover. DR ⎥ ( I − ρ A) −1 ⎢ 2 . stock market returns are predictable by conditional variances of risk factors. Appendix B shows that the log dividend yield is a linear function of conditional variances of stock market returns and discount-rate shocks: (4) 2 ⎡σ M ⎤ 1 ⎡ ⎤ dt − pt = C + ⎢γ − (γ − 1) β M . the predictive power of realized value premium variance becomes statistically insignificant. Consistent with this conjecture. the CAPM-based average IV can serve as a proxy for variance of the hedging factor omitted from CAPM. the two variables account for about 4% variation in stock market returns. the coefficient of realized value premium variance remains negative but becomes significant at the 1% level. As explained in the introduction. Before turning to the empirical results. Moreover. consistent with ICAPM. Table 1 shows that. Equation (4) shows that the log dividend yield is a linear function of the conditional log equity premium. when we add the average IV to the forecasting equation. the relation between realized stock market variance and future stock market returns is significantly positive.t ⎥ . in which the stock market serves as a hedge for changes in investment opportunities. Figure 1 shows that over the period 1963:Q3 to 2005:Q4. The negative coefficient is consistent with the implication of Campbell’s (1993) ICAPM. 7 . as expected. Row 3. we briefly explain the weak relation between the dividend yield and future stock returns.

t are perfectly correlated with each other. as in equation (B2). only if ( I − ρ A) −1 is an identity matrix—a ⎢ 2 ⎣ ⎦ ⎣σ DR . Andersen et al. in this paper. we construct the daily risk-free rate by assuming that it is constant within a month and that the daily risk-free rate compounds to the monthly risk-free rate.t and σ M . However. 3.t ⎥ . equation (3) collapses to the conditional CAPM. DR is equal to zero or if σ DR . realized stock market variance is the sum of squared daily excess stock market returns in a quarter: (5) MVt = ∑ ( ERM . Following Merton (1980). The excess stock market return is the difference between stock market returns and the risk-free rate. we find that stock market variance alone does not forecast stock market returns because proxies for 2 σ DR .t ⎦ 2 2 rather unrealistic assumption. in a multifactor model. Thus.2 1 ⎡ ⎤ ⎡σ M ⎤ γ− (γ − 1) β M . if (γ − 1) β M . the log dividend yield is proportional to the conditional equity premium because both variables are a linear function of conditional stock market variance. The monthly risk-free rate is also obtained from CRSP. DR ⎥ ⎢ 2 . d =1 Dt 8 . (2003).d ) 2 . Data We use the value-weighted stock market return obtained from CRSP as a proxy for aggregate stock market returns. Also. In this case. the fact that the log dividend yield is an infinite sum of expected future stock returns does not necessarily imply that it is a measure of the conditional equity premium. and many others.t are also a significant determinant of the equity premium.

vi . and Guo and Savickas (2006).t ⎤ v IVt = ∑ wi . Throughout the paper.d −1 ⎥ with wi .t −1 .t −1 is the market capitalization of stock i at the end of quarter t-1. we also try to correct for the serial correlation in daily returns and find essentially the same results.d − α − β ⋅ ERM .d + 2∑ ei .d −1 is less than zero.d −1 from d =1 Di . Following French et al. (1987). and (3) 9 .t equation (2) if ∑ ei2.where ERM .t is the market share of stock i. (2) the 500 largest stocks. unless otherwise indicated. We calculate the daily idiosyncratic shock using CAPM: (7) ei .d + 2∑ ei.d is the excess return on stock i and α and β are ordinary least squares (OLS) estimates using daily data over the period d-130 to d-1.t ⎢ ∑ ei2.d = ERi . we include only common stocks in the construction of the average IV. we require a minimum of 45 daily observations in the OLS regression. ei . Goyal and Santa-Clara (2003).t Nt ⎡ Di .d ei . We also exclude stocks with less than 15 return observations in a quarter and drop the autocorrelation term 2∑ ei . which.t measures of the average IV by using (1) the 100 largest stocks. we construct three d =1 d =1 Di . for brevity. (2001).t −1 j =1 where N t is the number of stocks in quarter t.d is the excess stock market return for day d and Dt is the number of trading days in quarter t. and wi . the value-weighted average idiosyncratic variance is (6) Di .d .d is the idiosyncratic shock to stock i in day d. where ERi . i =1 d =1 ⎣ d =1 ⎦ ∑ v j .d ei .d ei.t Di .t = Nt i . To obtain less-noisy estimates. are not reported here. Similar to Campbell et al. For robustness.

Lastly. consistent with Campbell et al. 6 10 . the equalweighted average IV has trended upward since the late 1940s. For robustness. they have moved closely to each other since the late 1940s. The two measures are almost perfectly correlated with each other over the period 1926:Q4 to 2005:Q4. although it decreased substantially at the end of our sample. N Our quarterly sample for the average IV spans the 1926:Q4 to 2005:Q4 period. One possible explanation is that. There are a few big spikes in the late 1920s and early 1930s. We find substantial difference between the two measures.t = 1 in equation (6). panel C plots the average IV for all stocks.6 We also construct the equal-weighted average IV assuming wi .and value-weighted average IVs is much larger for small stocks than big stocks. Because small stocks are more vulnerable to idiosyncratic shocks than big stocks. 7 Campbell and Thompson (2005) have emphasized that we should use CRSP total stock market return data. A daily return of over 300% mainly reflects the idiosyncratic shock. To summarize. which is also substantially lower than its equal-weighted counterpart. we are likely to find that equal-weighted average IV is UNITED GAS IMPT CO had a return of 317. we also experiment with filtering out daily returns higher than 100% and find that such a filter has negligible effects on our measures of the average IV. In particular.all stocks. However. the difference between the equal. the average IV has two components—variance of the risk-factor omitted from CAPM and variance of idiosyncratic shocks. 1943. This single observation will cause a big spike in our measures of idiosyncratic variance for 1943:Q3 if it is included in our calculation.7 Panel A. the trend is much less pronounced for the value-weighted average IV.592% on August 20. during which the stock market was extremely volatile due to the confounding effects of the 1929 crash and the Great Depression. Figure 2 plots both equal-weighted (thick line) and value-weighted (thin line) average IV constructed from the 100 largest stocks. we exclude it because we interpret the average IV as a proxy for the variance of the risk-factor omitted from CAPM. which are available only after 1926: The earlier return data are potentially unreliable because they are constructed with interpolated dividends. as shown in equation (1). however. Panel B plots the average IV for the 500 largest stocks. therefore. We notice some difference between the equal-weighted and the valueweighted measures in the early period. (2001).

(2003). as pointed out by Merton (1980). Table 2 provides summary statistics for the three main variables used in the paper: Excess stock market return (RET). use the value premium as a proxy for the hedging factor and estimate ICAPM with a bivariate GARCH model and daily data. as we confirm below. Interestingly. they provide a good indication of future variances. who find a positive relation between the firm-level stock return and volatility. This result also suggests that. (1987). panel B. right scale). during the 1929 crash. To investigate whether the spikes have large effects on our inference. realized stock market variance (MV).8 Thus. In particular. especially for smaller stocks. These results suggest that lagged realized variances might help forecast stock market returns because. Consistent with early studies. with an autocorrelation coefficient of 0. we observe a few big spikes in realized stock market variance. we primarily use lagged stock market Guo et al. Figure 3 plots realized stock market variance (thick line. and the 1987 crash. respectively. with a correlation coefficient of about 0. the contemporaneous relation between stock market returns and the average IV is positive.64. the contemporaneous relation between stock returns and variance is negative over the period 1926:Q4 to 2005:Q4. (2005) find qualitatively similar results in the estimation of ICAPM by using both the realized variance model and the GARCH model. the value-weighted average IV is a better proxy for the conditional variance of the risk factor omitted from CAPM than its equal-weighted counterpart. They also provide simulation results to show that both models provide reliable inference in samples with size similar to that of the post-World War II period. and the value-weighted average IV constructed from the 100 largest stocks. in the simulation. The latter result is consistent with Duffee (1995). Similar to the average IV.50 and 0. we also use a log transformation for stock market variance and the average IV. Andersen et al.62. left scale) along with excess stock market returns (thin line. Table 2 shows that both stock market variance and idiosyncratic variance are serially correlated. for example. Lastly. French et al. the subsequent Great Depression. and many others. Then they use simulated daily data from the GARCH estimation to estimate ICAPM with both 8 11 . Guo et al.higher than its value-weighted counterpart. We also observe relatively strong comovement between stock market variance and the average IV.

as we show below. DR IVt + ε t +1 .t +1 − rf . as we will show later. We use the value-weighted average IV constructed from the 100 largest stocks. and find that both models are able to capture the relation between the first and second moments of the risk factors. Note that both forecasting variables in equation (8) are substantially less persistent than those commonly used in the early studies. and we have to mainly rely on realized variances in our empirical analysis. Equation (8) is our main empirical specification. Several studies.variance and lagged average IV as proxies for conditional stock market variance and conditional variance of shocks to investment opportunities. Panel A. e. A. the data of implied variance are available for only a short sample period. Consistent with this finding. Unfortunately. therefore. find that implied variance estimated from options contracts provides a better measure of conditional stock variance than lagged realized variance. we find essentially the same results using the value-weighted average IV constructed from the 500 largest stocks or all stocks. 4. The predictive power of realized stock market variance by itself is statistically quarterly realized variance model and monthly bivariate GARCH model. We calculate the t-value using the Newey-West (1987) corrected standard error with 4 lags. Table 3 reports the results for the full sample spanning the period 1927:Q1 to 2005:Q4. we show that using implied variance substantially enhances stock return predictability. Average Idiosyncratic Variance and Expected Stock Market returns In-Sample Forecasts Table 3 presents the OLS (ordinary least squares) regression results of forecasting onequarter-ahead excess stock market returns. Christensen and Prabhala (1998) and Fleming (1998). (8) RM ..t +1 = γ MVt + (γ − 1) β M . and rewrite equation (3) as.g. they are potentially less vulnerable to the small sample bias emphasized by Stambaugh (1999). 12 . respectively.

the Wald test indicates that their joint forecasting power is statistically significant at the 1% level. stock market variance includes variances of both the cash-flow shock and the discount-rate shock. This result is consistent with the maintained hypothesis that the average IV is a proxy for the conditional variance of the discount-rate shock. when we include both variables in the forecasting regression.28. Therefore. Also. The coefficient of the average IV is negative. multicollinearity cannot explain our results because it usually leads to low tstatistics. which has never been 9 Because of the correlation between realized stock market variance and the average IV. (1980) confirms that multicollinearity is unlikely to plague our results. Table 3 also reports the results of two subsamples: 1927:Q1 to 1963:Q4 (panel B) and 1964:Q1 to 2005:Q4 (panel C).insignificant (row 1).9 As we have explained in Section 2. respectively—with an adjusted R-Squared of about 4% (row 3). the effect becomes statistically significant at the 5% and 1% levels for realized stock market variance and the average IV. Therefore. with a point estimate of –1. In row 3 of Table 3. there is a positive relation between conditional stock market return and variance. there is a potential concern with multicollinearity. the negative relation between stock market returns and the average IV—a proxy for the conditional variance of the discount-rate shock—serves as a correction for the overpricing. with a point estimate of 2. which has a negative coefficient in equation (3) if γ —the coefficient of conditional stock market variance—is greater than 1. the coefficient of realized stock market variance is positive. and the average IV alone does not forecast stock market returns either (row 2).98. the characteristicroot-ratio test proposed by Belsley et al. the discount-rate shock is overpriced in CAPM. For robustness. The first subsample. However. Moreover. in contrast with the increase of t-statistics when both variables are included. The result that realized stock market variance and the average IV forecast stock market returns jointly but not individually reflects an omitted variable problem. Because the discount-rate shock is not as risky as the cash-flow shock. However. 13 . consistent with Campbell’s (1993) ICAPM.

investigated before, provides an out-of-sample test for Guo and Savickas’ (2006) evidence. The results from the first subsample are almost identical to those obtained from the full sample. When they enter the forecasting regression separately, neither realized stock market variance (row 4) nor the average IV (row 5) is a significantly predictor of stock market returns. However, the effect of these variables becomes significant at the 5% and 1% levels for stock market variance and the average IV, respectively, when both variables are included in the forecasting equation (row 6). Also, in the multivariate regression, while the coefficient of realized stock market variance is positive, it is negative for the average IV. Consistent with Guo and Savickas (2006), we also find essentially the same results for the second subsample. Note that the coefficients of both variables are rather stable in two subsamples. This result explains that, as we show below, realized stock market variance and the average IV have significant out-of-sample predictive power for stock returns.

B.

Log Transformations of Variances

As shown in Figures 2 and 5, the average IV and realized stock market variance have a few big spikes. To investigate whether the results reported in Table 3 are sensitive to the influence of these potential outliers, we use log transformations of both variables in the forecasting regression, and Table 4 shows that the results are qualitatively similar. For the full sample (panel A), the coefficients of log realized stock market variance (LMV) and log average IV (LIV) are significant at the 5% and 1% levels, respectively, when we include both variables in the forecasting regression (row 3). Also, while log realized stock market variance is positively related to future stock market returns, the relation is negative for log average IV. We also find qualitatively similar results in two subsamples.

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C.

Bootstrapping T-Statistics

Table 2 shows that both realized stock market variance and the average IV are serially correlated; and they are also correlated with stock market returns. Therefore, the OLS estimates can be potentially biased in small samples (see, e.g., Stambaugh, 1999). To address this issue, we use the bootstrapping approach to obtain the empirical distribution of the t-statistics. In particular, we assume that stock market returns, realized stock market variance, and the average IV follow a joint VAR(1) process with the restrictions under the null hypothesis that the expected excess stock market return is constant. We estimate the VAR system using the actual data and then generate the simulated data 10,000 times by drawing estimated error terms with replacements. Table 5 reports the p-value of the t-statistic obtained from the bootstrapping, which are consistent with those from the asymptotic distribution reported in parentheses. The small sample bias has small effects on our inference possibly because Table 2 shows that our forecasting variables are substantially less persistent than are those cautioned by Stambaugh (1999), for example, the dividend yield. For brevity, in the remainder of the paper, we use the asymptotic distribution of the t-statistic.

D.

Alternative Measures of Average Idiosyncratic Variance

Because small stocks are more vulnerable to idiosyncratic shocks, using big stocks or the value weighting scheme to construct the average IV may provide a better measure for the conditional variance of the omitted risk factor. To illustrate this point, Table 6 investigates some alternative measures of the average IV. We find essentially the same results using the valueweighted measures constructed from the 500 largest stocks (row 2) and all stocks (row 4). The results are somewhat mixed for the equal-weighted measures. We find essentially the same results for the equal-weighted measure constructed from the 100 largest stocks (row 1). This 15

result should not be a surprise because panel A, Figure 2 shows that the equal-weighted and value-weighted measures for the largest 100 stocks are almost perfectly correlated with each other. However, the results are substantially weaker for the equal-weighted average idiosyncratic variance constructed from the 500 largest stocks (row 3) and all stocks (row 5). For robustness, we also repeat the above analysis using log transformations of both realized stock market variance and the average idiosyncratic variance, and find similar results (as shown in Table 7). To summarize, as expected, the average IV constructed from large stocks performs better than the average IV constructed from small stocks in the forecasting regression. For brevity, in the remainder of the paper, we focus on the value-weighted idiosyncratic variance constructed from the 100 largest stocks.

E.

Forecasting One-Year Ahead Excess Stock Market Returns

As a robustness check, we investigate whether realized stock market variance and the average IV at the last quarter of the previous year forecast the excess stock market return in the following year. Because we have considerably few observations for the annual regression, the results are potentially more vulnerable to outliers than are those obtained from the quarterly regression. To partially address this concern, we use log transformations of the forecasting variables in panel A. Consistent with the results obtained from quarterly data, log average IV is negatively and significantly related to the one-year-ahead excess stock market return. Log realized stock market variance is also positively related to future stock returns; however, such a relation is statistically insignificant possibly because of the relative small sample size. Overall, the Wald test indicates that their joint predictive power is statistically significant at the 5% level. Figures 2 and 5 show that both the average IV and realized stock market variance have a dramatic spike following the 1929 stock market crash. If we drop this potential outlier and run 16

which are obtained from Amit Goyal at Emory University. (2005). Similarly. the adjusted R-squared increases sharply from 3. the coefficient of the average IV is always statistically significant at the 5% level. Control for Other Predictive Variables This subsection compares the forecasting power of realized stock market variance and the average IV with that of the variables commonly used in the existing literature.the regression using the sample period 1932 to 2005. Consistent with the results obtained from quarterly data. panel B shows that the both log realized stock market variance and log average IV have significant effects on future stock market returns. in panel C. which is the ratio of twelve-month moving sums of net issues by NYSE listed stocks divided by the total market capitalization of NYSE stocks. we show that the average IV and stock market variance have significant predictive power for the one-month-ahead excess stock return by using options-implied variances. Similarly. This result might reflect the fact that realized variances are poor measures of conditional variances at the monthly frequency.2% in panel A to 7. Table 9 shows that the coefficient of realized stock market variance remains statistically significant at the 5% level except when we control for the net equity expansion (NTIS). we use the raw predictive variables to forecast stock returns over the period 1932 to 2005. In subsection H. we find negligible predictability in monthly data. the Wald test indicates that 17 . Consistent with the results in Bali et al. F. Also. and find qualitatively the same results.9% in panel B. it is negative for the average IV. Overall. while the effect of stock market variance is positive. indicating that the 1929 crash does have a confounding effect on our inference. We consider a total of fourteen additional forecasting variables.

we compare the performance of our forecasting model with a benchmark model of constant stock market returns. Therefore. For ENC-NEW and MSE-F tests. which is substantially below the 5% asymptotic and bootstrap critical values. The MSE ratio between the forecasting model and the benchmark model is 0.10 To summarize. the ENC-NEW test statistic is 12.two forecasting variables are jointly significant at the 5% level except when we control for the consumption-wealth ratio (CAY) proposed by Lettau and Ludvigson (2001). we report both asymptotic and bootstrap 5% critical values.95. As in Lettau and Ludvigson (2001).66. Goyal and Welch (2006) find that CAY does have out-of-sample predictive power for stock returns but caution that it might come from a look-ahead bias because CAY is estimated using the full sample. 18 . We obtain the same conclusion using the MSE-F test. Similarly. and labor income. wealth. realized stock market variance and the average IV jointly provide information about future stock returns beyond the variables commonly used in the early studies. the encompassing test (ENC-NEW) proposed by Clark and McCracken (2001). The second row of Table 10 10 CAY is the error term from the cointegration relation among consumption. we use the first one-third of the sample (1927:Q1 to 1953:Q1) for the initial in-sample regression and then make out-of-sample forecast for the remainder of the sample recursively. G. the difference between the forecasting model and the benchmark model is statistically significant. and the equal forecast accuracy test (MSE-F) proposed by McCracken (1999). suggesting that on average the forecasting model has substantially smaller squared forecasting errors than does the benchmark model. The first row of Table 10 reports the results for realized stock market variance and the average IV in levels. We use three test statistics to gauge the relative performance of the two models: The mean-squared error (MSE) ratio. Out-of-Sample Forecasts As in Lettau and Ludvigson (2001) and others.

realized stock market variance and the average IV have significant out-ofsample forecasting power for excess stock market returns. For comparison. Similarly.reports the results for realized stock market variance and the average IV in logs. which are qualitatively the same as those reported in the first row. and we find that our results are not driven by any particular episode. To summarize. the value corresponding to June 1953 is the MSE ratio over the forecast period 1953:Q2 to 2005:Q4. Alternative Measures of Stock Market Variance and Idiosyncratic Variance We calculate realized variance using 5-minute S&P500 cash index over the period 1986:Q1 to 2004:Q4—the longest sample available to us—and plot it (thick line) in Figure 6. the two measures move closely to each other. we also plot realized variance constructed using daily stock return data (thin line). Table 11 presents the OLS regression results of forecasting stock market returns using realized stock market variance constructed from both daily (panel A) and 5-minute (panel B) 19 . In general. The MSE ratio is always less than 1. We choose the range 1953:Q2 to 2000:Q4 for the starting forecast date. therefore. However. we do observe an important difference: Realized stock market variance is substantially lower for 5-minute data than daily data at 1987:Q4. we use at least 20 observations for the calculation of the MSE ratio. with a correlation coefficient of 0.77. indicating that realized stock market variance and the average IV jointly have strong out-of-sample forecasting power for excess stock market returns. H. Figure 4 plots the recursive MSE ratio of the forecasting model (in row 1 of Table 10) to the benchmark model of constant stock returns through time. The horizontal axis denotes the starting date for the out-of-sample forecast: For example. Figure 5 plots the difference in MSE between the benchmark model of constant stock returns and the forecasting model (in row 1 of Table 10).

5-minute data generate an adjusted R-squared substantially higher than do daily data. implied variance has a significantly positive effect on future stock market returns when it is the only forecasting variable (row 6). We use the end-of-period observations for both monthly and quarterly data. Jointly. the forecasting power of both implied variance and the average IV is significant at the 1% level. The Wald test indicates that the joint predictive power of the two variables is significant at the 1% level. Panel B. Table 12 shows that evidence of stock return predictability is substantially stronger in quarterly data than in monthly data: Over the same sample period. we also use the end-of-period implied variance as a proxy for conditional stock market variance. we use the period 1986:Q2 to 2004:Q4. (2003). The difference likely reflects the fact that. however. Table 12 shows that the results are qualitatively similar to those obtained using quarterly realized variances. In panel C of Table 11. To improve the efficiency of estimations. we can estimate realized variance more precisely by using higher-frequency data. the adjusted R20 . To be comparable with the results obtained from the 5-minute data. as pointed out by Merton (1980) and Andersen et al.data. we also use the end-of-quarter implied variance estimated from options contracts on the S&P 100 index as a proxy for conditional stock market variance. we construct the daily value-weighted idiosyncratic variance using stock-level options-implied variances obtained from the OptionMetrics database. The results for both measures are qualitatively similar. Lastly. Panel A report the regression results for monthly data. By contrast with realized variance constructed from both daily and 5-minute data. While stock market variance by itself has insignificant predictive power (row 1). its effect becomes significant at the 1% level after we also include the average IV in the forecasting equation (row 3). while we find qualitatively similar result using the monthly and quarterly averages. Despite the relative short sample. which spans the period February 1996 to December 2005. with an adjusted R-squared of over 15% (row 7).

Thus. The portfolio returns are calculated using the value weight. we expect a negative relation between lagged returns on stocks with high IV and future excess stock market returns. This interpretation is plausible because the average IV is closely correlated with realized value premium variance—which has been argued to be a proxy for systematic risk—and the two variables have similar forecasting power for stock returns. 5. To summarize. we are more likely to detect stock return predictability in quarterly data than monthly data. we first sort stocks equally into two portfolios by size.squared is about 23% for quarter data. Is the CAPM-Based Idiosyncratic Variance a Proxy for Risk? Further Tests We have shown that the average IV has significant forecasting power for stock market returns when combined with stock market variance. and then within each size portfolio we sort stocks equally into three portfolios by IV. we conduct further tests on whether the CAPM-based idiosyncratic variance is a proxy for risk. One possible explanation of this result is that the average IV is a proxy for conditional variance of the hedging factor omitted form CAPM. compared with 4% for monthly data. 21 . This evidence is consistent with the fact that we find significant stock return predictability using realized variances in quarterly data but not in monthly data. Lagged Portfolio Returns and Expected Stock Market Returns Equation (1) shows that the average IV is a proxy for the conditional variance of the discount-rate shock possibly because stocks with high IV are more sensitive to the discount-rate shock than are stocks with low IV. To address this issue. In this section. Also. A. using better measures of conditional stock market variance and idiosyncratic variance substantially enhances stock return predictability.

By contrast. there is a very close relation between the value effect and the IV effect. we follow their approach closely here. in a way similar to that of Fama and French (1996) in their construction of the value premium. to be comparable with the results reported in Eleswarapu and Reinganum (2004). As we show in the next subsection. 22 . the predictive power of lagged stock market returns is insignificant at the 10% level. we use the returns on stocks with high IV in the previous 12 quarters to forecast excess stock market returns in the following 4 quarters. We also construct a hedging portfolio. Panel A. As hypothesized. which includes the periods of the 1929 crash. while the predictive power is negligible for value stocks. By contrast. Table 13 shows that lagged returns on the hedging portfolio also forecasts excess stock market returns. Table 13 presents the regression results.Eleswarapu and Reinganum (2004) find that high lagged returns on growth stocks predict low future stock market returns. and the World War II. we calculate the return difference between the portfolio with low IV stocks and the portfolio with high IV stocks. IVF is then the equal-weighted average of such a difference across small and big stocks. In particular. the Great Depression. Therefore. The lagged returns on the hedging portfolio are positively related with future stock market returns because the hedging portfolio has a short position in high IV stocks. the predictive power is statistically insignificant for lagged returns on stocks with low IV. IVF. lagged returns on the stocks with high IV is negatively related to future stock market returns. Panel B. for both small and big stocks. with the p-value obtained through bootstrapping in parentheses. over the post-1950 period. and such a relation is significant at the 5% level. makes it difficult to draw any precise inference. for both small and big stocks. In particular. The choice of the post-1950 sample also reflects the fact that the volatile stock market in the pre-1950 sample.

Ang et al. in which the SDF is a linear function of the proposed risk factors. compared with 79% for the Fama and French (1996) three-factor model. Interestingly. the risk premium on the excess stock market return (MKT) is also significantly positive. We find that IVF is indeed closely correlated with the value premium. and Hahn and Lee (2006) show that the value premium is related to shocks to state variables that forecast stock market returns. In particular. For robustness. because Eleswarapu and Reinganum (2004) find that high lagged returns on growth stocks also forecast low future stock market returns. This conjecture is plausible also because Brennan et al. Petkova (2006). One possibility is that IVF could be a proxy for the discount-rate shock. IVF is significantly priced in the Fama and MacBeth (1973) regression. with a correlation coefficient of about 45% over the sample period 1964:Q1 to 2005:Q4. Campbell and Vuolteenaho (2004). Overall. (2006) show that the return difference between stocks with low IV and stocks with high IV cannot be easily diversified away. IVF should have explanatory power similar to that of the value premium. however.B. the three risk factors jointly account for 83% variation in cross-sectional average portfolio returns. Panels B to D of Table 14 provide diagnostic tests using the stochastic discount factor (SDF) models. the size premium (SMB) is not priced in our sample. More importantly. An immediate implication of this result is that IVF—the return on the hedging portfolio that is long (short) in stocks with low (high) IV—should help explanation the cross-section of stock returns. (2004). 23 . In panel A. IVF and the Cross-Section of Stock Returns Consistent with the conjecture that IV is a proxy for loadings on the discount-rate shock. Table 14 shows that IVF performs as well as or somewhat better than the value premium in explaining the cross-section of returns on the 25 Fama and French (1996) portfolios sorted by size and the book-to-market ratio. we have found that high lagged returns on stocks with high IV predict low future stock market returns.

and such a relation is statistically significant at the 10% level. With this caveat in mind. we test the models using the distance measure (Dist) proposed by Jagannathan and Wang (1996) and Hansen and Jagannathan (1997). the Wald test indicates that the joint predictive power of realized stock market variance and IVF is 24 . For the first two weighting matrices. realized variance of IVF by itself has negligible predictive power for stock market returns (row 1).we use three different weighing matrices: Identity weighting matrix (panel B). We find that the IVF performs substantially better than the value premium. as advocated by Hansen and Jagannathan (1997). Table 15 investigates the time-series ICAPM implication that realized variance of IVF (V_IVF) forecasts excess stock market returns. However. Realized Variance of IVF and Expected Excess Stock Market Returns We have shown that the hedging factor IVF performs as well as or somewhat better than the value premium. its effects become significantly negative after we also include realized stock market variance in the forecasting equation (row 2). Ahn and Gadarowski (2004) have noted that the test based on the distance measure tends to reject the true model too often in small samples. Again. Moreover. In particular. the model with IVF as a risk factor is not rejected at the 1% level for the identity weighting matrix. Panel A shows that over the full sample spanning the period 1927:Q1 to 2005:Q4. We use Hansen’s (1982) J-test for the optimal weighting matrix. our results suggest that IVF appears to perform quite well in explaining the cross-section of stock returns. and at the 10% level for the optimal weighting matrix. while the Fama and French 3-factor model is overwhelmingly rejected in all three specifications. realized stock market variance is positively related to future stock market returns. and Hansen’s (1982) optimal weighting matrix. inverted covariance matrix of the portfolio returns. C. at the 5% level for the Hansen and Jagannathan weighting matrix.

Table 15 shows that IV+ is statistically insignificant at the conventional level in the two subsamples. For brevity. Thus. with a correlation coefficient of 83% over the period 1926:Q4 to 2005:Q4. To investigate whether the forecasting power of the average IV mainly come from its close relation with the conditional variance of the discount-rate shock. we orthogonalize the average IV by realized variance of IVF and use the residual (IV+) to forecast stock market returns. which also shows that the results are qualitatively similar by using the 25 . the two variables also have very similar predictive power for stock returns. We find qualitatively similar results in two subsamples (as shown in panels B and C). Campbell’s (1993) ICAPM indicates that it is predictable by its own variance and the variance of the stock market return. For brevity. it is not a surprise that realized variance of IVF is closely correlated with realized value premium variance. as hypothesized. Therefore. Forecasting Returns on Hedging Portfolios If IVF is a proxy for the return on the hedging portfolio. In particular. the latter result is not reported here but is available on request.significant at the 5% level. these results are not reported here but are available on request. it is only marginally significant in the full sample. Similarly. with an adjusted R-squared much smaller than those reported in Table 3. the forecasting power of the average IV is closely correlated with that of the conditional variance of shocks to the discount rate. This conjecture is strongly confirmed by the results presented in Table 16. Moreover. D. with a correlation coefficient of 88%. Realized variance of IVF and the average IV are also closely correlated. We have shown that IVF is closely correlated with the value premium over the period 1964:Q1 to 2005:Q4. as well as by estimating a monthly bivariate GARCH model with IVF as the hedging factor. we expect that IVF is positively correlated with its own variance and negatively correlated with stock market variance.

variance of stock-level idiosyncratic shocks is not necessarily idiosyncratic. Table 14 shows that it has substantial pricing errors. Also. Some Discussions If IVF is priced because it is a proxy for the discount-rate shock. They find that these firms experienced significant increases in both stock prices and volatility after the announcements. we can use it to control for systematic risks in the construction of the idiosyncratic shock. However. While one cannot rule out the possibility of data mining.. e. Mazzucato (2002) studies 11 The positive relation between the idiosyncratic risk and the stock price is consistent with the finding by Duffee (1995) and the results reported in Table B2.g. 26 . IVF is just an empirical risk factor and is vulnerable to measurement errors. controlling for IVF has negligible effects on our main finding of a positive relation between the average IV and future stock market returns. for brevity. Second. although we cannot reject the model at some conventional significance levels. We find a similar result using the other potential risk factors. this result is not reported here but is available on request. E. the value premium and the momentum profit. We also find qualitatively similar results for the value premium over the period 1964:Q1 to 2005:Q4.11 Similarly.average IV as a proxy for the variance of the hedging factor. idiosyncratic risk accounts for a large portion of variation in a stock’s price and thus leads to the imprecise estimation of the factor loadings. it can be correlated with changes in investment opportunities. at the individual stock level. For example. Together. (2004) conduct an event study using a sample of “brick and mortar” firms that announced their initiation of eCommerce in the late 1990s. For example. we offer three other alternative explanations. First. Agarwal et al. these two concerns suggest that including IVF as an additional risk factor might not appropriately account for the systematic risk at the stock level.

and Pastor and Veronesi (2005) examine American railroads from 1830 to 1861. firm volatility—as measured with both real variables and stock prices— increases sharply when there are radical technological changes. it does not qualitatively change our main result possibly because IVF is a noisy measure of the omitted risk factor. Also. Figure 7 shows that although the average industry IV is substantially smaller than the average stock IV. as defined in Grinblatt and Moskowitz (1999).and value-weighting schemes. These authors find that. we construct the average industry IV using 20 industry portfolios. which leads a stock to be overpriced initially but to suffer a capital loss eventually (Miller. following Diether et al. We find that the average dispersion of analysts’ earning forecasts has negligible forecasting power for stock market returns either by itself or in conjunction with conditional stock market variance. auto industry from 1899 to 1929 and the U.S. 1977). (2002). and they have similar forecasting power for stock market returns. To address this possibility. in these industries. To illustrate this point. Miller’s hypothesis cannot explain (1) why the predictive power of the average IV is closely related to that of realized variances of the value premium and IVF and (2) why IVF helps explain the cross-section of stock returns.the U. we use dispersion of analysts’ earning forecasts obtained from the IBES database as a measure of dispersion of opinion and aggregate them across stocks using both equal. idiosyncratic variance might also be a measure of dispersion of opinion. 27 . however.S. Lastly. Also. PC industry from 1974 to 2000. which also initially drove up the stock prices of the firms in these industries. the two move closely to each other. by contrast with the average stock IV. controlling for IVF has some noticeable effects on the measure of the average industry IV.

Conclusion In this paper. and this result holds up in a number of robustness checks. 28 . in which conditional excess stock market returns are a linear function of conditional stock market variance and variance of shocks to the discount rate. Over the period 1927:Q1 to 2005:Q4. consistent with ICAPM.6. we propose a couple of forecasting variables following the intuition of Campbell’s (1993) ICAPM. stock market returns are predictable by variances of risk factors. the average idiosyncratic variance and realized stock market variance jointly forecast stock market returns in sample and out of sample. While the discount-rate shock is not directly observable. we show that the average CAPM-based idiosyncratic variance is potentially a good proxy for variance of the hedging factor omitted from CAPM. Our results suggest that.

We construct the CAPM-based idiosyncratic shock by regressing individual excess stock returns on excess stock market returns: (A4) ˆ ERi . M ( ERM .t − E t −1 ( ERM . where ε i .t = β i .t ) = β M .t − N DR .t + ε i2.t ERM .t = ηi2.t ) and the discount-rate shock ( N DR . DR ( ERM .t is the idiosyncratic shock that is orthogonal to stock market returns and the discountrate shock.t + ηi .t − Et −1 ( ERi .t = β i2DRε DR . i.t − Et −1 RDR .t is the return on a hedging portfolio.t ): (A1) ERM .t . we can write the ex-post excess return on any asset as (A2) ERi .t ) + ε i .t .t ) + ε DR . Stock market returns and the discount-rate shock are correlated: (A3) RDR .t ) + β i .t − Et −1 ( RDR .Appendix A If stock returns are predictable. . realized IV is the sum of squared daily idiosyncratic shocks in period t.t . DR ( RDR . discount rates are a measure of investment opportunities. 29 .. If RDR . For ease of illustration.t ) = β i .t .t is the estimated loading on stock market returns in period t.t .t . RDR .t − Et −1 ERM . ˆ where β i .t has the perfect correlation with N DR . However.e.t ) = N CF . in equation (A5) we assume that realized IV for period t is the squared idiosyncratic shock of period t. in our empirical implementation. It is then straightforward to show that realized CAPM-based IV of stock i is (A5) 2 IVi .t − Et −1 ERM . In Campbell’s (1993) ICAPM. we decompose the unexpected excess stock market return into the cash-flow shock ( N CF .

30 .t and σ DR . as (B1) dt − pt = − κ 1− ρ + Et ∑ ρ j (rM . we can rewrite equation (3) as 2 (B2) 1 2 2 E t (rM . DRσ DR .t +1 ) = Et (rM .t + (γ − 1) β M .Appendix B We follow Campbell and Shiller (1988) and write the log dividend yield.t +1 ⎤ ⎡ σ M .t follow a joint VAR(1) process: (B3) 2 2 ⎡ σ M .t +1 ⎤ ⎢ 2 ⎥ = A0 + A ⎢ 2 ⎥ + ⎢ ⎥. Note that these three assumptions should not affect our main results in any qualitative manner.t ⎦ where C is a collection of the constant terms.t . rM .t +1 ⎦ ⎣σ DR .t +1 = (γ − )σ M .t ⎦ ⎣ε 2. 2 2 2 For simplicity. DR ⎥ ( I − ρ A) ⎢ 2 ⎥ . 2 ⎣ ⎦ ⎣σ DR .t + j +1 − Δd t + j +1 ) . j =0 ∞ where − κ 1− ρ is a constant.t ⎤ ⎡ ε1. Then it is straightforward to show that (B4) ⎡ 2 ⎤ 1 ⎡ ⎤ −1 σ M . Using the relation E t ( RM . Table B1 provides empirical evidence of equation (B4).t dt − pt = C + ⎢γ − (γ − 1) β M .t + j +1 is the log stock market return. dt − pt .t +1 ⎦ We also assume that the expected dividend growth and the risk-free rate are constant. ⎣σ DR . and Δdt + j +1 is the dividend 1 2 growth rate.t .t +1 ) − rf . we assume that the conditional variances σ M .t +1 ) + σ M .

V_HML is available over the period 1963:Q4 to 2005:Q4. ***.130 V_IVF t-value V_HML t-value -0.203 31 .745 IV -0.517 Adjusted RSquared 0. and * denote significant at the 1%. MV is realized stock market variance. 5%.195*** 0.333 0. and all the other variables are available over the period 1926:Q4 to 2005:Q4.017 -0. and V_HML is realized value premium variance.567 2. MV 1 2 3 0.514*** t-value -5.152*** t-value 7.319*** 0.122 3. IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks. **.Table B1 Realized Variances of Risk Factors and the Dividend Yield Note: The table reports OLS regression results of the dividend yield on variances of risk factors. and 10% levels. We calculate the t-value using the Newey-West corrected standard error. V_IVF is realized variance of the hedging portfolio that is long (short) in stocks with low (high) idiosyncratic variance.074 0. respectively.283*** -3.132** -2.

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297 Adjusted R-Squared 0. and * denote significant at the 1%. We calculate the tvalue using the Newey-West corrected standard error.011 t-value -1.118 -2.939 -9.534 -1. respectively.002 0.255 IV t-value -1.255*** -2.Table 1 Average Idiosyncratic Variance and Value Premium Variance: 1963:Q4 to 2005:Q4 Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return. and 10% levels. 5%.598** 2. **.981 -0.036 0. MV is realized stock market variance.039 37 .888** t-value 2. and V_HML is realized value premium variance. ***. IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.236 2. MV 1 2 3 2.322 V_HML -3.

014 -0. RET.106 1. and the excess stock market return.Table 2 Summary Statistics: 1926:Q4 to 2005:Q4 Note: The table reports summary statistics of the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.000 Mean Standard Deviation Autocorrelation 0. MV. Univariate Statistics 0.000 -0.619 38 .080 0.014 0.008 0. IV.139 0. realized stock market variance. Cross-Correlation 1.021 0. RET MV IV RET MV Panel A.000 0.013 0.114 0.643 Panel B.504 IV 1.

309** 1.Table 3 Forecasting One-Quarter-Ahead Excess Stock Market Return Using Variances Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.872** 1.089 0.044 39 .326 -3.004 0.011 0. We calculate the tvalue using the Newey-West corrected standard error.802 2.824*** -1.003 0.031 Panel C 1964:Q1 to 2005:Q4 7 8 9 1.343 -0. respectively.000 Panel B 1927:Q1 to 1963:Q4 4 5 6 0.041 2.333 -4. ***. and * denote significant at the 1%.977*** -1.762 2.043 Panel A 1927:Q1 to 2005:Q4 1 2 3 0. MV t-value IV t-value Wald Test p-value Adjusted RSquared 0.456 -2.738 -1.470* 2. Wald test is the test for the joint significance of MV and IV.518 2. 5%.284** 1.587 -1.198 0.003 -0.274 -0.442 0. MV is realized stock market variance and IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.008 0. and 10% levels. **.896 -3.009 0.003 0.009 -0.177*** -0.002 0.941 2.

and * denote significant at the 1%.002 0. respectively.004 -0.246 -0.018 Panel C 1964:Q1 to 2005:Q4 7 8 9 0.695 -0.008 -0.576 -2.027 Panel A 1927:Q1 to 2005:Q4 1 2 3 0.029*** 1.003 0.003 -0.487 1.013 -0.028** 0.843 -0. LMV is the log of realized stock market variance and LIV is the log of the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.002 Panel B 1927:Q1 to 1963:Q4 4 5 6 0.383 0.009 0.003 0.026 40 .012 -0.021 0.945 2.049 -0.007 0.037* 0. Wald test is the test for the joint significance of LMV and LIV. **.040*** -1. LMV t-value LIV t-value Wald Test p-value Adjusted RSquared 0.039** -0. We calculate the t-value using the Newey-West corrected standard error.393 0.002 0. and 10% levels.Table 4 Forecasting One-Quarter-Ahead Excess Stock Market Return Using Log Variances Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.010 0.582 0.640 -2.057** -0. 5%. ***.254 2.170 -3.

013) 0. ***.019 (0.028** 0.043 2 0. we assume that excess stock market returns (RET). In particular. For comparison.000) Adjusted R-Squared 0.010) IV p-value Panel A Variances in Levels -1. and the CAPM-based idiosyncratic variance (IV) follow a joint VAR(1) process with the restrictions under the null hypothesis that the expected excess stock market return is constant. and 10% levels. **. and * denote significant at the 1%.026 (0.000) Panel B Variances in Logs -0.000 times by drawing estimated error terms with replacements.000 (0.000 (0. according to the empirical distributions.Table 5 Bootstrapping t-Values: 1927:Q1 to 2005:Q4 Note: The table reports the p-value of the t-statistic obtained from the bootstrapping for the regression of forecasting the one-quarter-ahead excess stock market return. 5%. realized stock market variance (MV). We estimate the VAR system using the actual data and then generate the simulated data 10.027 41 .040*** 0. MV 1 2. we also report the asymptotic p-value in parentheses. respectively.284** p-value 0.977*** 0.

053 Value-Weighted All Stocks -1.066 0.213* 1.717 -1.619 0. and * denote significant at the 1%.899 Equal-Weighted All Stocks -0.755*** -4.411*** Wald Test p-value Equal-Weighted 100 Largest Stocks 2.117 0.Table 6 Different Measures of Idiosyncratic Variance: 1927:Q1 to 2005:Q4 Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return. ***.000 0. and 10% levels.500*** 0. Wald test is the test for the joint significance of MV and IV.033 5 0. respectively. MV t-value 1 2.416 0.718*** -3.130 -0.039 3 1.991** 2.041 2 2.663 0.111 IV t-value Adjusted RSquared 0.411*** -3.014 -0. **.001 Value-Weighted 500 Largest Stocks 2.723 -1.000 Equal-Weighted 500 Largest Stocks -0.893 0.235** 2. 5%. MV is realized stock market variance and IV is the CAPM-based average idiosyncratic variance.006 42 .299 0. We calculate the t-value using the Newey-West corrected standard error.007 4 2.

259 0.077*** Equal-Weighted All Stocks -0. Wald test is the test for the joint significance of LMV and LIV.030*** 0.023 3 0. 5%.021** 0.000 43 .047*** -3.664 -0.723 -0. We calculate the t-value using the Newey-West corrected standard error.153 0. respectively.001 Equal-Weighted 500 Largest Stocks 2.012 1.701 2 0.020 -1.042*** -3.877 0.030 1 0.357 0. LMV is the log of realized stock market variance and LIV is the log of the CAPM-based average idiosyncratic variance.603 0. ***. and 10% levels.032 -3.005 4 0.Table 7 Different Measures of Idiosyncratic Variance in Logs: 1927:Q1 to 2005:Q4 Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.016 5 0.024** 2. LMV t-value LIV t-value Wald Test p-value Adjusted RSquared 0. **.005 -0.005 0.032*** Equal-Weighted 100 Largest Stocks 2.064 0.000 Value-Weighted 500 Largest Stocks 2.074 Value-Weighted All Stocks -0.279 -0. and * denote significant at the 1%.

056) 0.031 44 .043 Wald Test p-value Panel A 1927 to 2005 with Variances in Logs -0.701 13.871 (0.032 4 5 6 0.Table 8 Forecasting One-Year-Ahead Excess Stock Market Return Note: The table reports OLS regression results of forecasting the one-year-ahead excess stock market return.079 0.056 -1. 5%. respectively.988** -1.115*** -2.405 5.024 0. **. and 10% levels. MV is realized stock market variance and IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.522 -1.337** Panel C 1932 to 2005 with Variances in Levels 1. We use the non-overlapping data: MV and IV are quarterly variances at the last quarter of the previous year.003 0.276 -3.960 (0. Wald test is the test for the joint significance of MV and IV.029 -0.104** -2. and * denote significant at the 1%.001) 3. ***. We calculate the t-value using the Newey-West corrected standard error.009 0.011 0.767 2.773 IV t-value Adjusted R-Squared -0.047 Panel B 1932 to 2005 with Variances in Logs 1. MV t-value 1 2 3 -0.436 -0.088*** 7 8 9 1.278 -0.090 -0.003 -0.867 4.505 1.009 0.717 -0.406 0.007 -0.029 0.031 -0.

023 0.778* 1. and * denote significant at the 1%.162** 2.272** 2.000 0.295** 2.000 0. LTY is the yield on long-term Treasury bonds.274 2.089 0.253** 0.065*** -1. BAA is the yield on Baa-rated corporate bonds. LTR is the return on long-term Treasury bonds.421 IV -1.433 X 0.556 -3.360 2.239 2.133 -4.095 -0.031 45 .047 0. E12 is the earning-price ratio.911*** -1.186 2.052 0.096 0.302** -0.054 0.375 2.707 -0.555 2. AAA is the yield on Aaa-rated corporate bonds.503 -0.063 0.159** 1.140 -0.182 1.549 -0.427 -4. **.974*** -1. X stands for the forecasting variables listed in the first column.396 0.299 2.631*** -1.Table 9 Control for Additional Predictive Variables Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return. BM is the book-to-value ratio.123 -4.289 1.003 0.000 0.000 0.679*** -1.337 2.380 2.359 1. ***.206 Wald Test p-value 0.901*** -2.040 0.259* 0.000 0.114 0.188** 2.314 2.198** 2.000 0.000 0.262** -1.814 0. MV D12 E12 BM TB1 AAA BAA LTY CAY NTIS RFREE INFL LTR CORPR CSP 1.267 -2.439 -4.875 2.744 2. and CSP is the cross-sectional beta premium proposed by Polk et al (2006).061*** -2.117 -3.918** t-value 2. RFREE is the short-term interest rate.701** 2.003 1.457 t-value 1.040 0.046 0.018 3.283** 1. D12 is the dividend yield. NTIS is net equity expansion.427 -4.069 -0.040 0.875 0.000 0.019*** -2.005 0.207 -4.927*** t-value -3. and 10% levels.041 0. MV is realized stock market variance and IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.261 -3. CAY is the consumption-wealth ratio proposed by Lettau and Ludvigson (2001).633 0.002 0.341 2.930*** -1.439*** 0.049 0. TB1 is the yield on 1-year Treasury bonds.520 -0. respectively.926 -4.496** 1.752** 2. CORPR is the return on long-term corporate bonds. Wald test is the test for the joint significance of MV and IV.040 0.322 2.522* 2. 5%.125 0.000 Adjusted R-Squared 0.280** 2.307** 2.245 -4.000 0.044 -4. LINFL is the inflation rate.049 0.696 0.735*** -1.991*** -2. We calculate the t-value using the Newey-West corrected standard error.040*** -1.

C MSE A / MSEB 0.66 13. CV 12. CV 1. of which we set the initial values to their unconditional means. and (3) the equal forecast accuracy test MSE-F developed by McCracken (1999).11 1. The Asy. We report three out-of-sample forecast tests: (1) the mean-squared forecasting error (MSE) ratio of the augmented model to the benchmark model.52 BS. The BS.98 ENC-NEW Statistic Asy. (2) the encompassing test ENC-NEW developed by Clark and McCracken (2001). Models 1 2 C+MV +MV vs. MV.58 2.36 46 .Table 10 Tests of Out-of-Sample Forecast Performance Note: We assume that excess stock market returns are constant in the benchmark model and augment the benchmark model with realized stock market variance. We then feed the saved residuals with replacements to the estimated VAR system.95 0. CV 1. CV column reports the asymptotic 95 percent critical values provided by Clark and McCracken (2001) and McCracken (1999).92 2.52 1. In particular. The ENC-NEW and MSE-F statistics are calculated using the simulated data and the whole process is repeated 10.09 2. C C+LMV +LIV vs. we first estimate a VAR (1) process of excess stock market returns and its forecasting variables with the restrictions under the null hypothesis. and the value-weighted idiosyncratic variance constructed from the 100 largest stocks.99 Statistic 10.79 5. We use the log transformations of these variables row 2.09 BS.000 times. as in Lettau and Ludvigson (2001). We use observations over the period 1927:Q1 to 1953:Q1 for the initial in-sample estimation and then generate forecasts recursively for stock returns over the period 1953:Q2 to 2005:Q4.064 MSE-F Asy. IV in row 1. CV column reports the empirical 95 percent critical values obtained from the bootstrapping. / . CV 2.

387 1.051 Panel B Daily Data 1 2 3 0. 5%.713 -2.995** 3.010 0.033 0.825 -2.080 0.460*** 0.012 0.552 2.879*** -2. is realized stock market variance constructed using 5-minute data in panel B. and is implied variance constructed using options contracts on the S&P 100 index.Table 11 Alternative Measures of Stock Market Variance Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.226 -3.278 -1.592 -1.093 6 7 1.697*** -4. We calculate the t-value using the Newey-West corrected standard error. ***.000 -0.213 7. The sample spans the period 1986:Q2 to 2004:Q4.154 0. respectively. IV is the CAPM-based average idiosyncratic variance constructed from the 100 largest stocks. and * denote significant at the 1%.023 3.153 47 .495*** -5.733** 0.004 Panel B 5-Minute Return Data 4 5 1.031 0.000 0. and 10% levels. Wald test is the test for the joint significance of MV and IV.771 0.668 2. MV t-value IV t-value Wald Test p-value Adjusted R-Squared -0.952*** Panel C Options-Implied Stock Market Variance 2. MV is realized stock market variance constructed using daily data in panel A. **.

Wald test is the test for the joint significance of MV and IV. We calculate the t-value using the Newey-West corrected standard error.082*** -2.228 48 .722 -0.235 0. ***.653 -0.000 MV t-value IV t-value Adjusted R-Squared 0. 5%.126*** -3. respectively.043 0.001 Panel B Quarterly Data: 1996:Q2 to 2005:Q4 2.910 1.043 4 5 6 7. MV is the implied variance constructed using options contracts on the S&P 100 index and IV is the value-weighted average options-implied variances of common stocks.844 4.154 -0.006 0.515*** -5. and * denote significant at the 1%.007 0.458 -0.169 -1. and 10% levels.342*** 2. **.049 0. 1 2 3 Wald Test p-value Panel A Monthly Data: February 1996 to December 2005 1.Table 12 Idiosyncratic Variance Constructed with Options-Implied Variance Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.352 4.134*** 0.556 0.987** 18.

MKT is the excess stock market return. **. respectively.030) RSQ 0. Panel A Lagged Returns on Portfolios Sorted by Size and IV Low IV RSQ High IV 1 2 Small Big -0.076 3 Panel B Lagged Returns on Risk Factors MKT RSQ IVF -0.258** (0.037 0. We also construct a hedging portfolio. we calculate the return difference between the portfolio with low IV stocks and the portfolio with high IV stocks. In parentheses we report the bootstrapped p-value.392 0. IVF. for both small and big stocks.121) (0. 5%.320) -0.016 -0.021) RSQ 0.048) -0.010 0. and then within each size portfolio we sort stocks equally into three portfolios by idiosyncratic variance.509** (0.Table 13 Forecasting Stock Market Returns with Lagged Portfolio Returns Note: We sort stocks equally into two portfolios by size.055 0.361** (0. and 10% levels.169 (0. IVF is then the equal-weighted difference across small and big stocks. The portfolio returns are calculated using the value weight. We use the portfolio returns in the previous 12 quarters to forecast excess stock market returns in the following 4 quarters over the period 1950 to 2005. and * denote significant at the 1%. In particular.075 49 . in a way similar to that of Fama and French (1996) in their construction of the value premium.273) 0.260 (0. ***.

240) 8.598) 8.658*** (4. IVF is the return on a hedging portfolio that is long (short) in stocks with low (high) idiosyncratic variance. ***.Table 14 Cross-Sectional Regressions Note: MKT is the excess stock market return.053) 7 8 4. and Hansen’s (1982) optimal weighting matrix in panel D.531) 7.788) 6.833 (-1. Panel A reports the Fama and MacBeth (1973) cross-Sectional regression results.124) 50 .331) 4.830*** 0.300) (8. we use three different weighting matrices: the identity matrix in panel B. HML and SML are the value premium and the size premium. of the Fama and French (1996) 3-factor model.907*** (4.301 (7.560*** (3. in which SDF is a linear function of risk factors. Panels B to D estimate the stochastic discount factor (SDF) models.020** 0.000) 0.365 (0.658) 0.737*** (4.696 (0. We test the model specifications using Jagannathan and Wang’s (1996) distance measure (Dist) in panels B and C and Hansen’s J-test in panel D.016 0. in panel C.890*** 0.045 (0.392) 3 4 3.002) 29. We test the asset pricing models using 25 Fama and French portfolios sorted by size and the book-to-market ratio over the period 1964:Q1 to 2005:Q4.758 (0.717) 0. **.009** (2. Const MKT HML SMB IVF R2 Dist (p-value) J-test (p-value) 1 2 0.387) 42. 5%.791 (3.208) (0.815*** 9.971) Panel D SDF with Optimal Weighting Matrix 7.992) Panel B SDF with Identity Weighting Matrix 5.998*** 0.824*** (4.390*** (3. and * denote significant at the 1%. respectively.722) 0.031** (2.014*** -0.282) (1.049) (0. as suggested by Hansen and Jagannathan (1997).047) 5 6 3.033** (2.522) (0.818*** (5.191*** 6.003) 31.121) -0.018 0.487*** (3.196) (5.970 (0.715 (5.008* (1.181) (4.249) 46.079) 4.034 (0.538) 0.983*** 7.147*** (5.101) Panel C SDF with HJ Weighting Matrix 5. For robustness. respectively. the inverted covariance matrix of the portfolio returns.124*** (6.061) Panel A Fama and MacBeth Regressions 0. and 10% levels.021) (-1.

040 -1.004 0.016 -0.Table 15 Forecasting One-Quarter-Ahead Stock Market Return with Realized Variance of IVF Note: The table reports OLS regression results of forecasting the one-quarter-ahead excess stock market return.034 0.177 1.012 0.326 -1.152 51 .742 0.560* Panel B 1927:Q1 to 1963:Q4 -0. and 10% levels.027 -1.876 0. IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks. MV t-value V_IVF t-value IV+ t-value Wald Test p-value Adjusted R-Squared -0.100 0.158** 1.201*** -2.252 1. 5%.198 -0.098* 1. We calculate the t-value using the Newey-West corrected standard error.768* 1.011 1 2 3 4 5 6 7 8 9 1.038* -1.968 -1.277 Panel C 1964:Q1 to 2005:Q4 -1. **.756* 2.981 1.027 0.822 1.003 0. MV is realized stock market variance.014 0. and * denote significant at the 1%. Wald test is the test for the joint significance of the forecasting variables.932 Panel A 1927:Q1 to 2005 -0.403** 1. and V_IVF is realized variance of the hedging portfolio that is long (short) in stocks with low (high) idiosyncratic variance.873 0. respectively. IV+ is the residual from the regression of IV on a constant and V_IVF.001 0.033 -0. ***.092*** -2.238 -1.005 0.875 -1.676 2.008 0.854 -2.284 -1.068 -1.559 -2.586 1.

019 0.321 3.000 0.030*** Panel B 1927:Q1 to 1963:Q4 6 7 8 9 10 -0.046 0.003 0. and 10% levels.068 -1. respectively.045*** Panel C 1964:Q1 to 2005:Q4 11 12 13 14 15 -2.432 -2.282 2.007 0.000 -0.567 4.742 2.246** 0.057 -0.730 -1.173** -2. ***.260 3.555 0.560** 1.042 0.013 0. **.006 0.679** -2.654 0.059 Panel A 1927:Q1 to 2005 1 2 3 4 5 -0.026 0.676* -1.953 2.013 0. MV is realized stock market variance.771** 2.016 0. MV t-value V_IVF t-value IV t-value Wald Test p-value Adjusted R-Squared 0.074 0.011 0.001 52 .940 -2.004 0.709** -0. We calculate the t-value using the Newey-West corrected standard error.256 -1.001 0. and V_IVF is realized variance of IVF.887*** 1.225 0.439** -3.249 2.007 2.244 -2.060 2.288 -2.781 0.779** 2. and * denote significant at the 1%.Table 16 Forecasting One-Quarter-Ahead Returns on the Hedging Portfolio Note: The table reports OLS regression results of forecasting the one-quarter-ahead IVF—the return on the hedging portfolio that is long (short) in stocks with low (high) idiosyncratic variance.022** 1.728** -4.346 1. 5%.056*** -1. Wald test is the test for the joint significance of the forecasting variables. IV is the CAPM-based average idiosyncratic variance constructed using the 100 largest stocks.366*** 2.528 0.777 0.039 0.514* 1.029 0.414 -2.075 2.

1 0. Left Scale) and Value-Weighted Idiosyncratic Variance Constructed Using 100 Largest Stocks (Thin Line.01 0.05 0 0 Sep-63 Sep-68 Sep-73 Sep-78 Sep-83 Sep-88 Sep-93 Sep-98 Sep-03 53 .02 0. Right Scale) 0.Figure 1: Realized Value Premium Variance (Thick Line.

2 0 Dec-26 Dec-36 Dec-46 Dec-56 Dec-66 Dec-76 Dec-86 Dec-96 54 .4 0.3 0.Figure 2 Equal.(Thick Line) and Value-Weighted (Thin Line) Average IV Panel A: 100 Largest Stocks 0.4 0.1 0 Dec-26 Dec-36 Dec-46 Dec-56 Dec-66 Dec-76 Dec-86 Dec-96 Panel B: 500 Largest Stocks 0.6 0.3 0.2 0.2 0.1 0 Dec-26 Dec-36 Dec-46 Dec-56 Dec-66 Dec-76 Dec-86 Dec-96 Panel C: All Stocks 0.

8 0.4 0.9 0.Figure 3 Stock Market Variance (Thick Line.8 0.15 0. Left Scale) and Returns (Thin Line.05 -0.2 0.7 Jun-53 Jun-58 Jun-63 Jun-68 Jun-73 Jun-78 Jun-83 Jun-88 Jun-93 Jun-98 55 . Right Scale) 0.4 0 Dec-26 Dec-36 Dec-46 Dec-56 Dec-66 Dec-76 Dec-86 Dec-96 -0.8 Figure 4 Recursive MSE Ratios 1 0.1 0 0.

03 0 -0.03 Jun53 Jun58 Jun63 Jun68 Jun73 Jun78 Jun83 Jun88 Jun93 Jun98 Jun03 Figure 6 Realized Stock Market Variance Constructed from 5-Minute (Thick Line) and Daily (Thin Line) Stock market Returns 0.05 0 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 56 .Figure 5 Differences in MSE between Benchmark Model and Forecasting Model 0.1 0.

Figure 7 Value-Weighted Average IV Constructed from the 100 Largest Stocks (Thick Line) and 20 Industry Portfolios (Thin Line) 0.1 0.02 0.01 0 Dec-26 0 Dec-36 Dec-46 Dec-56 Dec-66 Dec-76 Dec-86 Dec-96 57 .05 0.