Abstract

http://ssrn.com/abstract=1561262
 
 

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When Does Idiosyncratic Risk Really Matter?


Tony Ruan


Xiamen University

Qian Sun


Fudan University

Yexiao Xu


University of Texas at Dallas - School of Management

February 28, 2010


Abstract:     
In contrast to the current literature, we provide new evidence supporting a positive relation between idiosyncratic risk and the expected future market return. Since a large part of the idiosyncratic risk can be diversified away easily, the conventional aggregate idiosyncratic risk measures can only be noisy proxies for the undiversified idiosyncratic risk, which may be priced according to Merton (1987). We thus propose a simple noise reduction method that includes two different noisy measures (dual-predictor) in the same predictive regression to reexamine the relation. We show that the noise effect tends to cancel out in our framework due to the highly correlated noise components of the two measures. In particular, our dual-predictor alone explains future market returns with an adjusted R^2 of 4%. Such a large predictive power is economically significant and robust to the inclusion of other popular predictors and to the choices of sample periods and additional market indices.

Number of Pages in PDF File: 52

JEL Classification: G12, G14, G17

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Date posted: February 28, 2010 ; Last revised: September 21, 2010

Suggested Citation

Ruan, Tony and Sun, Qian and Xu, Yexiao, When Does Idiosyncratic Risk Really Matter? (February 28, 2010). Available at SSRN: http://ssrn.com/abstract=1561262 or http://dx.doi.org/10.2139/ssrn.1561262

Contact Information

Tony Ruan
Xiamen University ( email )
Xiamen, Fujian 361005
China
Qian Sun
Fudan University ( email )
No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China
Yexiao Xu (Contact Author)
University of Texas at Dallas - School of Management ( email )
P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-6703 (Phone)
HOME PAGE: http://www.utdallas.edu/~yexiaoxu
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