Is idiosyncratic risk ignored in asset pricing: Sri Lankan evidence?

Moinak Maiti

doi:10.1186/s43093-019-0004-6

Abstract

The present study focused on one of the important South Asian nations—Sri Lanka—to examine the role of idiosyncratic volatility in asset prices. A four-factor model with idiosyncratic volatility was designed for capturing the market, size, value and idiosyncratic risk yields better than Fama and French’s (J Financ Econ 33:3–56, 1993) three-factor model and performance of the model. Fama–MacBeth’s cross-sectional regression, residual graphs and GRS test all confirm the superiority of four-factor model over 2 three-factor models. For all MC- and IVOL-based portfolios, idiosyncratic volatility is negatively related to the expected returns and positively related for all PB-based portfolios. Finally, study findings confirm that there is a high importance for idiosyncratic volatility risk factor while considering investment decision in Colombo stock exchange. Hence, investor should compensate for holding such risk factors in the portfolio.

Highlights

Risk is broadly classified into two groups: one systematic and another unsystematic
Market (Rm) coefficients of all portfolios based on Market capitalisation (MC), P/B and idiosyncratic volatility (IVOL) are highly positive and significant
Size (SMB) coefficients are positive for small-size portfolios and become negative towards big-size portfolios in case of MC-based portfolios, whereas SMB coefficients are mostly positive in case of P/B- and IVOL-based portfolios

Summary

Introduction

Risk is broadly classified into two groups: one systematic and another unsystematic. Systematic risk is a risk which cannot be diversified like market risk, whereas unsystematic risk can be diversified, and systematic risk should be priced by the investors. Present study uses three risk-mimicking portfolios SMB (size), LMH (value) and LvMHv (idiosyncratic volatility), and they are estimated as described below:2 Three factor regressions (market, size and idiosyncratic volatility) Portfolio P11 (first portfolio) is well captured by the model for MC-, P/B- and IVOL-based portfolios.

Results

Conclusion