Is Idiosyncratic Risk Quantitatively Significant?

Rajnish Mehra, Sunil Wahal, Daruo Xie

NBER Working Paper No. 22016
Issued in February 2016, Revised in April 2017
NBER Program(s):Asset Pricing

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify this model to allow the degree of diversification to vary with average idiosyncratic volatility. This simple recognition results in a state-dependent idiosyncratic risk premium that is higher when average idiosyncratic volatility is low, and vice versa. We conduct a series of empirical tests to assess the presence and magnitude of the premium. In the US, in periods when average idiosyncratic volatility is low, the premium is significant and positive in both small and large capitalization stocks. We observe similar premia in markets outside the US.

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Document Object Identifier (DOI): 10.3386/w22016

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