Idiosyncratic risk and the cross-section of expected stock returns

✍ Scribed by Fangjian Fu

• Book ID: 113711087
• Publisher: Elsevier Science
• Year: 2009
• Tongue: English
• Weight: 284 KB
• Volume: 91
• Category: Article
• ISSN: 0304-405X
• DOI: 10.1016/j.jfineco.2008.02.003

✦ Synopsis

Theories such as Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483–510] predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang [2006. The cross-section of volatility and expected returns. Journal of Finance 61, 259–299], however, find that monthly stock returns are negatively related to the one-month lagged idiosyncratic volatilities. I show that idiosyncratic volatilities are time-varying and thus, their findings should not be used to imply the relation between idiosyncratic risk and expected return. Using the exponential GARCH models to estimate expected idiosyncratic volatilities, I find a significantly positive relation between the estimated conditional idiosyncratic volatilities and expected returns. Further evidence suggests that Ang et al.'s findings are largely explained by the return reversal of a subset of small stocks with high idiosyncratic volatilities.