Idiosyncratic Volatility and the Pricing of Poorly-Diversified Portfolios
25 Pages Posted: 3 Jun 2011 Last revised: 10 Nov 2015
Date Written: May 31, 2011
This article examines the role of idiosyncratic volatility in explaining the cross-sectional variation of size- and value-sorted portfolio returns. We show that the premium for bearing idiosyncratic volatility varies inversely with the number of stocks included in the portfolios. This conclusion is robust within various multifactor models based on size, value, past performance, liquidity and total volatility and also holds within an ICAPM specification of the risk-return relationship. Our findings thus indicate that investors demand an additional return for bearing the idiosyncratic volatility of poorly-diversified portfolios.
Keywords: idiosyncratic risk, cross-sectional variation in stock returns, CAPM, conditional volatility, risk premium
JEL Classification: G12, G14
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