Idiosyncratic Jump Risk Matters: Evidence from Equity Returns and Options

Abstract

The recent literature provides conflicting empirical evidence on the relationship between idiosyncratic risk and equity returns. This paper sheds new light on this relationship by exploiting the richness of option data. We disentangle four risk factors that potentially contribute to the equity risk premium: systematic Gaussian risk, systematic jump risk, idiosyncratic Gaussian risk, and idiosyncratic jump risk. First, we find that systematic risk factors explain close to 60% of the risk premium on average, while idiosyncratic factors explain more than 40%. Second, we show that the contribution of idiosyncratic risk to the equity risk premium arises exclusively from the jump risk component. Tail risk thus plays a central role in the pricing of idiosyncratic risk.