0
$\begingroup$

I am studying idiosyncratic volatility. After applying the Fama Frech 3 Factor model with its Marktet, SMB and HML factors I want to build a factor based on idiosyncratic volatility.

Can I just build a portfolio including the highest idiosyncratic volatility assets and one with the lowest idiosyncratic volatility and subtract those from each other ?

My factor would then be:

IVOL factor = excess return of highest IVOL portfolios - excess returns of lowest IVOL portfolios

I could either used the 20% highest/lowest or just build the median and then assign them to one of the portfolios.

I am not sure if this approach is correct.

Best wishes

$\endgroup$

1 Answer 1

1
$\begingroup$

Are you doing this in an academic context? If so, the standard factor portfolio procedure is the Fama-French construct, which involves building 6 portfolios (split by size into 3/4/3 buckets and high/low based on your score) then average of the small and big. If you're doing this in an industry/work context, calculating average quintile/decile excess returns will suffice.

$\endgroup$
3
  • $\begingroup$ Thanks a lot! It is for an academic paper. What do you mean with "split by size into 3/4/3 buckets"? From my understanding I would construct the portfolio just like the Fama-French HML factor which would give me instead of: HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth) the following: HML_idiosyncratic = 1/2 (Small_high idiosyncratic volatility + Big_idiosyncratic volatilty) - 1/2 (Small_low idiosyncratic volatility + Big_low idiosyncratic volatility) Does that sound correct to you?Sorry for the formatting this is my first post here $\endgroup$
    – John
    Jan 3, 2021 at 9:25
  • $\begingroup$ Here is an example for B/M [mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/…. The 30%/40%/30% split is what I'm referring to. When Ken French says "Portfolios are formed on BE/ME at the end of each June using NYSE breakpoints", he meant the size bucket "breakpoints" should be based on NYSE-listed stocks, then applied to NASDAQ and Amex stocks. The reason you do this is that NYSE tends to be larger than NASDAQ and Amex. If you calculate small/big buckets using all stocks then the small bucket will contain all the NASDAQ/Amex stocks $\endgroup$
    – stevew
    Jan 4, 2021 at 8:39
  • $\begingroup$ Thank you so much! $\endgroup$
    – John
    Jan 13, 2021 at 14:45

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.