Volatility Decomposition - Empirical Patterns of the Idiosyncratic Risk on the Swedish Stock Market

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: We decompose total stock market volatility into market-, industry- and firm-specific components to empirically explore if and how the level of idiosyncratic volatility has changed over time. The econometric methods of Campbell, Lettau, Malkiel and Xu (2001) are applied to the Swedish stock market 1985 to 2004. We find evidence for an upward trend and show that there is a significant increase in idiosyncratic volatility over time. Industry-specific volatility shows a weaker upward trend and market-specific volatility remains flat. The firm-specific volatility tends to lead the other series and market-specific volatility tends to lead industry-specific volatility. None of the volatility series have the power to forecast GDP growth or market returns. We suggest that a higher degree of competition on the market and an increase of newly listed firms during the bull-market of the late 1990s contribute to the upward trend in idiosyncratic volatility.

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