Fractional non-diversifiable risk and stock market returns

Abstract

ABSTRACT This article introduces a new risk metric of stock returns. It measures the fraction of the non-diversifiable risk relative to the individual risk of a typical stock in the stock market and is shown to be closely related to average correlation between individual stocks. Using the Korean stock market data, we show that the fractional non-diversifiable risk varies over time, and in particular, sharply rises during the financial crisis periods. We find that the relation between risk and return at the aggregate level is negative contemporaneously, but positive with a time lag. As a robustness check, we extend our analysis to the U.S. and the U.K. markets. Our results shed light on resolving the conflicting risk and return relations reported in the literature.