Network Factors for Idiosyncratic Volatility Spillover
Abstract
This paper examines changes in the network structure of idiosyncratic volatility spillover among sectors, as captured by two asset pricing factors: the Concentration factor and the Magnitude factor. These factors determine the distribution of node sizes and linkage thicknesses in an idiosyncratic volatility spillover network, and contain distinct sources of systematic risk. The Concentration factor measures the extent to which contamination capacity is dominated by a few large sectors, while the Magnitude factor measures the average probability of idiosyncratic volatility spillover. The Concentration factor is associated with a positive price of risk, while the Magnitude factor is associated with a negative price of risk. Cross-sectional tests show that stocks with greater exposure to the Concentration factor are riskier, with an annual return spread of +5%, while those with greater exposure to the Magnitude factor are hedges, with an annual return spread of -4%. These return gaps cannot be explained by standard asset pricing models, and the idiosyncratic volatility spillover network factors outperform the production-based network factors. Finally, I present a multisector model to shed light on how changes in the idiosyncratic volatility network affect aggregate volatility. Specifically, a higher Concentration factor and lower Magnitude factor can increase the cross-sectional decay rate, or “diversification speed,” of aggregate volatility as the number of sectors (n) goes to infinity.
