Can Asset Pricing Models Price Idiosyncratic Risk in U.K. Stock Returns?

Abstract

AbstractI examine how well different linear factor models and consumption‐based asset pricing models price idiosyncratic risk in U.K. stock returns. Correctly pricing idiosyncratic risk is a significant challenge for many of the models I consider. For some consumption‐based models, there is a clear tradeoff in the performance of the models between correctly pricing systematic risk and idiosyncratic risk. Linear factor models do a better job in most cases in pricing systematic risk than consumption‐based models but the reverse is true for idiosyncratic risk.