We document the existence of a common factor structure in option implied idiosyncratic variances.
We show that the average idiosyncratic variance, which proxies for the common factor, is priced in the cross section of equity returns, and that it reduces the pricing error when added to the Fama-French model.
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We model the index dynamics' P-distribution as a mean-reverting stochastic volatility model as in Heston (1993), and the equity returns as single factor models with stochastic idiosyncratic volatility terms.
We derive theoretically the underlying assets' Q-distributions and estimate the parameters of both P- and Q-distributions using a joint likelihood function.
We find that the idiosyncratic volatilities differ under P- and Q-measures, and we estimate the price of this idiosyncratic volatility risk, which turns out to be always significantly different from zero for all the stocks in our sample.
Further, we show that the idiosyncratic volatility risk premiums are not explained by the usuall equity risk factors.
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