Abstract
A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncratic risk is not priced by investors because in the absence of frictions it can be fully diversified away. In the presence of constraints on diversification, refinements of the CAPM conclude that the part of idiosyncratic risk that is not diversified should be priced. Recent empirical studies yielded mixed evidence with some studies finding positive correlation between idiosyncratic risk and stock returns, while other studies reported none or even negative correlation. We examine whether idiosyncratic risk is priced by the stock market and what are the probable causes for the mixed evidence produced by other studies, using monthly data for the US market covering the period from 1980 until 2013. We find that one-period volatility forecasts are not significantly correlated with stock returns. The mean-reverting unconditional volatility, however, is a robust predictor of returns. Consistent with economic theory, the size of the premium depends on the degree of ‘knowledge’ of the security among market participants. In particular, the premium for Nasdaq-traded stocks is higher than that for NYSE and Amex stocks. We also find stronger correlation between idiosyncratic risk and returns during recessions, which may suggest interaction of risk premium with decreased risk tolerance or other investment considerations like flight to safety or liquidity requirements. We identify the difference between the correlations of the idiosyncratic volatility estimators used by other studies and the true risk metric the mean-reverting volatility as the likely cause for the mixed evidence produced by other studies. Our results are robust with respect to liquidity, momentum, return reversals, unadjusted price, liquidity, credit quality, omitted factors, and hold at daily frequency.
Highlights
There have been long debates whether idiosyncratic risk is a significant factor in explaining the cross-section of stock returns, and if so, what the direction of that influence is
We demonstrate that the divergence of previous studies is due to differences of the correlation of their estimators with the mean-reverting volatility; the GARCH forecasts with monthly data are strongly correlated with the mean-reverting level of volatility, while the last-month return is less correlated to it and more correlated to short-term expected volatility, and is no a robust predictor of the cross-section of returns
Bali and Cakici (2008) compare predictive accuracy from running Mincer and Zarnowitz (1969) regressions using the volatilities from GARCH(1,1) and EGARCH(1,1) models filtered from the full available history of monthly returns for each security
Summary
There have been long debates whether idiosyncratic risk is a significant factor in explaining the cross-section of stock returns, and if so, what the direction of that influence is. The capital asset pricing model (CAPM) developed by Sharpe (1964) and Lintner (1965) proposes that in complete, frictionless markets the only factor that is priced by the market is the asset beta that measures the covariation of the assets’ returns with the return on the aggregate valueweighted portfolio comprising all the available assets in the economy. Levy (1978) developed a model that imposed a limit on the number of securities held by each investor, which resulted in investors holding underdiversified portfolios and bearing idiosyncratic risk. One of the most influential models explaining why idiosyncratic risk should be a priced factor was that of Merton (1987). The model assumes that investors are tracking only a subset of the asset universe and as a result of the incomplete diversification securities with higher idiosyncratic volatility in equilibrium should earn higher expected returns. Malkiel and Xu (2004) propose an extension of Merton’s model, which relax the assumption that idiosyncratic risk is uncorrelated across securities and demonstrate that the premium for idiosyncratic risk depends on the covariance of idiosyncratic risk with the market-wide undiversified idiosyncratic risk
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Free) 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
