Abstract
Stocks with increases in idiosyncratic risk tend to earn low subsequent returnsfor a few months. However, high idiosyncratic risk stocks eventually earnpersistently high returns. These results are consistent with positively pricedidiosyncratic risk and temporary underreaction to idiosyncratic riskinnovations. Because risk levels and innovations are correlated, the relationbetween historical idiosyncratic risk and returns may reflect both risk premiumsand underreaction and yield misleading inference regarding the price of risk.The results reconcile previous work offering conflicting evidence on the priceof idiosyncratic risk and help to discriminate among explanations for theidiosyncratic risk-return relation.
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