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Decomposition Of Total Volatility: How Important Is Idiosyncratic Risk?

Decomposition Of Total Volatility: How Important Is Idiosyncratic Risk? Indrani De, CFA, PRM and Joshua Nutman by The Finance Professionals' Post

Introduction

In recent years there has been a lot of debate about volatility, and the components of volatility. A lot has been said about the risk-on, risk-off market with a focus on macro and factor risks. There are many dimensions to volatility, and this paper uses the methodology of Campbell et al. (2001) to break down the total volatility in US equities into the three components of Market, Industry and Firm (idiosyncratic risk), and analyzes the trends in their share over time. We look at the time period January 2005 through December 2014, incorporating the years prior to, during and post financial crisis, and use S&P 500 as a proxy for the US equities, with the Global Industry Classification Standard (GICs) sector classification. The main conclusion is that there is a strong payoff to stock selection even in the post-financial crisis era where market participants often think of risk only in terms of risk-on and risk-off. The share of idiosyncratic risk indicating benefits of stock selection decreased a lot during the crisis. It is now at the highest level since the start of the financial crisis, though still much lower than in the pre-crisis...


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