Is Idiosyncratic Volatility Really Priced?

35 Pages Posted: 15 Mar 2011 Last revised: 2 Jun 2011

Date Written: March 14, 2011


Recent literature has documented both a positive and a negative relation between idiosyncratic risk derived from standard asset pricing models and return. Fu (2009) resolves this debate by explicitly modeling expected as opposed to total idiosyncratic risk and finds a strong positive relation between expected idiosyncratic volatility and returns, suggesting missing systematic risk factors or inefficient markets. We document that this positive relation between idiosyncratic volatility and returns only exists for small firms which are difficult to arbitrage. The relation between idiosyncratic volatility and returns is strong for the smallest quartile of stocks, but decreases with size and becomes non-existent for the largest quartile of firms. Furthermore, portfolios formed on size (as a proxy for the difficulty of arbitrage) and idiosyncratic volatility only yield economically significant Jensen (1968) alphas for small stock portfolios. However, due to the high costs of trading these stocks, zero-cost portfolios based on idiosyncratic volatility and size do not yield significant positive returns when conservative trading costs are considered. This implies that the compensation for bearing idiosyncratic risk is limited to stocks that are difficult to arbitrage and therefore does not suggest missing factors or inefficient markets. The results are robust to alternate measures of idiosyncratic volatility and the difficulty (cost) of arbitrage as well as across time. This evidence is consistent with an efficient market.

Keywords: Asset Pricing, Idiosyncratic Volatility, Risky Arbitrage, Market Efficiency, EGARCH

JEL Classification: G11, G12, G14

Suggested Citation

Bergbrant, Mikael C., Is Idiosyncratic Volatility Really Priced? (March 14, 2011). Available at SSRN: or

Mikael C. Bergbrant (Contact Author)

St. Johns University ( email )

8000 Utopia Parkway
Queens, NY 11439
United States
8134476288 (Phone)


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