Is Idiosyncratic Risk Priced? The International Evidence
51 Pages Posted: 21 Mar 2009 Last revised: 5 Nov 2012
Date Written: July 11, 2009
We examine the relation between expected returns and idiosyncratic risk across 44 countries from 1980 to 2007. Theory suggests that expected returns are unrelated to idiosyncratic risk if investors hold fully-diversified portfolios, and positively related if investors hold under-diversified portfolios. The empirical evidence to date has been decidedly mixed. In this study, we apply Fu’s (2009) EGARCH model to an international setting and provide supportive evidence for a positive and significant relation between expected returns and idiosyncratic risk – suggesting that the typical investor holds an under-diversified portfolio. Our international dataset also allows us to examine the relation between country-level determinants of investor under diversification and idiosyncratic risk premiums. We find that such risk premiums are larger in markets with lower investor wealth and higher investor risk tolerance. We also find that investor characteristics are more important determinants of the size of the idiosyncratic risk premium than are information and transaction costs. Our study makes two primary contributions. First, we verify the existence of a positive risk premium for idiosyncratic volatility using over seven million observations from 58,000 stocks across 44 markets. Second, and perhaps more important, we show that idiosyncratic risk premiums are directly attributable to investor under-diversification.
Keywords: Idiosyncratic risk, Expected returns, Pricing, International markets
JEL Classification: G12, G15
Suggested Citation: Suggested Citation