Yes / A key prediction of the Capital Asset Pricing Model (CAPM) is that idiosyncratic risk is
not priced by investors because in the absence of frictions it can be fully diversified
away. In the presence of constraints on diversification, refinements of the CAPM
conclude that the part of idiosyncratic risk that is not diversified should be priced.
Recent empirical studies yielded mixed evidence with some studies finding positive
correlation between idiosyncratic risk and stock returns, while other studies reported
none or even negative correlation. We revisit the problem whether idiosyncratic risk is
priced by the stock market and what are the probable causes for the mixed evidence
produced by other studies, using monthly data for the US market covering the period
from 1980 until 2013. We find that one-period volatility forecasts are not significantly
correlated with stock returns. The mean-reverting unconditional volatility, however, is a
robust predictor of returns. Consistent with economic theory, the size of the premium
depends on the degree of 'knowledge' of the security among market participants. In
particular, the premium for Nasdaq-traded stocks is higher than that for NYSE and
Amex stocks. We also find stronger correlation between idiosyncratic risk and returns
during recessions, which may suggest interaction of risk premium with decreased risk
tolerance or other investment considerations like flight to safety or liquidity
requirements. The difference between the correlations of the idiosyncratic volatility
estimators used by other studies and the true risk metric the mean-reverting volatility is
the likely cause for the mixed evidence produced by other studies. Our results are
robust with respect to liquidity, momentum, return reversals, unadjusted price, liquidity,
credit quality, omitted factors, and hold at daily frequency. / National Research Foundation of Korea (2016S1A2A2912265)
| Identifer | oai:union.ndltd.org:BRADFORD/oai:bradscholars.brad.ac.uk:10454/15562 |
| Date | 04 June 2018 |
| Creators | Bozhkov, S., Lee, H., Sivarajah, Uthayasankar, Despoudi, S., Nandy, M. |
| Source Sets | Bradford Scholars |
| Language | English |
| Detected Language | English |
| Type | Article, Published version |
| Rights | © The Author(s) 2018. This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made. |
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