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Abstract
Conservatism in the CAPM and L-CAPM standards often emphasizes systematic risk to explain the phenomenon of the risk-return relationship and ignores idiosyncratic risk with the assumption that the risk can be diversified. The effect of the Covid-19 outbreak raises the question of whether the idiosyncratic risk can still be ignored considering that the risk has a close relationship to firm-specific risk. This study sets a portfolio consisting of 177 active public firms in the Indonesia Stock Exchange before and after the Covid-19 pandemic. On portfolio set, idiosyncratic risk is estimated by the standard CAPM and L-CAPM in the observation range from January 2, 2019, to June 30, 2021. The results of the analysis show that L-CAPM and CAPM produce significantly different idiosyncratic risks. Empirical evidence shows that the highest firm-specific risk is in the third period and has a stable condition since the fourth period. This condition is confirmed by regression results that idiosyncratic risk together with systematic risk positively affects stock returns in the fourth period as suggested by the efficient market hypothesis. Uniquely, both systematic risk and idiosyncratic risk based on L-CAPM do not show a significant effect on stock returns in the fifth period, so it is a strong indication that liquidity is an important factor that must be considered in making investments.
Highlights
The capital asset pricing model (CAPM) is the most effective in explaining the risk and return relationship
Both systematic risk and idiosyncratic risk based on L-CAPM do not show a significant effect on stock returns in the fifth period, so it is a strong indication that liquidity is an important factor that must be considered in making investments
An understanding of the standard CAPM concept tends to focus only on systematic risk to explain the relationship between risk and return
Summary
The capital asset pricing model (CAPM) is the most effective in explaining the risk and return relationship. French et al (1987) demonstrate that the risk premium and expected stock returns are correlating positively. Lakonishok and Shapiro (1986) provide evidence that systematic risk could be positive to stock return when the market is at normal condition but negative while the market is down. Confirming those results, Theriou et al (2010) support that firms with higher systematic risks have higher returns as the market risk premium is positive but they will have lower returns as the market falls. Confirming those results, Theriou et al (2010) support that firms with higher systematic risks have higher returns as the market risk premium is positive but they will have lower returns as the market falls. Lakonishok and Shapiro (1986) provide interesting evidence that the idiosyncratic or unsystematic risk holds its role in circumstances of a not well-diversified portfolio
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