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NATIONAL BUREAU OF ECONOMIC RESEARCH
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Is Idiosyncratic Risk Conditionally Priced?

Rajnish Mehra, Sunil Wahal, Daruo Xie

NBER Working Paper No. 22016
Issued in February 2016, Revised in April 2019
NBER Program(s):The Asset Pricing Program

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify his 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. The data appear to be consistent with a positive state-dependent premium for idiosyncratic risk both in the US and in other developed markets.

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Document Object Identifier (DOI): 10.3386/w22016

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