14 – M4 L3b 14 IVol Value And Idiosyncratic Volatility Overview V2

The last alpha factor that we’ll construct is based on the paper titled “Arbitrage asymmetry and the idiosyncratic volatility puzzle.” This paper uses a lot of the concepts that we’ve learned, including a unique example of using some of the output of a risk model as part of alpha factor construction. Personally, I enjoy this example because we combined so much of what we have learned in addition to some more ideas from behavioral finance. Based on this paper, we’ll construct a conditional factor, a fundamental factor enhanced by a volatility factor. Let’s start with some background information that will help you interpret the meaning of the two factors that we’ll combine. We’ll first remind ourselves of how arbitrage supports efficient markets. Next, we’ll look at volatility and how volatility may limit arbitrage activities. Then we’ll look at the idiosyncratic portion of volatility and why this might be more useful as a factor than the total volatility. Then we’ll refresh the meaning of a value factor, which is a type of fundamental factor. Lastly, we’ll combine the value factor and idiosyncratic volatility into a joined factor. We’ll discuss generalizing what we’ve learned so that you can use your creativity and create related factors of your own.

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