Explanatory Differences in Idiosyncratic Volatility: Evidence from Fama-French Three- and Five-factor Models

Abstract

Based on the idiosyncratic volatility anomaly, this study discusses the differences between the interpretation of idiosyncratic volatility by FF-3 and FF-5 models and the interpretation degree and difference of the real return of A-shares after the addition of idiosyncratic volatility. Through the empirical analysis of data from FF-3 model to FF-5 model, this paper studies the explanatory degree of the two investment models on Chinese market pricing and whether the explanatory degree of the two models has significantly changed. It is found that the idiosyncratic volatility risk of stock pricing obtained by FF-5 model is significantly different from that obtained by FF-3 model, and the idiosyncratic volatility risk obtained by FF-5 model is 0.9092 times that obtained by FF-3 model. These differences are caused by the addition of two new factors, the profitability factor, and the investment level factor, from FF-3 to FF-5 models. However, even if the FF-5 model is good, it still has a poor explanation of expected returns in a long period of 8 years from March 2014 to March 2022. The explanation degree is lower than 50%, which is still a low level.