Idiosyncratic Risk and Security Returns

57 Pages Posted: 24 Jan 2001  

Yexiao Xu

University of Texas at Dallas - School of Management

Burton G. Malkiel

Princeton University - Bendheim Center for Finance; National Bureau of Economic Research (NBER)

Date Written: May 2004

Abstract

The traditional CAPM approach argues that only market risk should be incorporated into asset prices and command a risk premium. This result may not hold, however, if some investors can not hold the market portfolio. For example, if one group of investors fails to hold the market portfolio for exogenous reasons, the remaining investors will also be unable to hold the market portfolio. Therefore, idiosyncratic risk could also be priced to compensate rational investors for an inability to hold the market portfolio. A variation of the CAPM model is derived to capture this observation as well as to draw testable implications. Under both the Fama and MacBeth (1973) and Fama and French (1992) testing frameworks, we find that idiosyncratic volatility is useful in explaining cross-sectional expected returns. We also discover that returns from constructed portfolios directly co-vary with idiosyncratic risk hedging portfolio returns.

Keywords: APT, CAPM, Cross-sectional Regression, Imperfect Market Portfolio, Idiosyncratic Risk, Risk Premium

JEL Classification: G12

Suggested Citation

Xu, Yexiao and Malkiel, Burton G., Idiosyncratic Risk and Security Returns (May 2004). AFA 2001 New Orleans Meetings. Available at SSRN: https://ssrn.com/abstract=255303 or http://dx.doi.org/10.2139/ssrn.255303

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

Burton G. Malkiel

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Princeton University - Bendheim Center for Finance ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States
609-258-6445 (Phone)
609-258-0771 (Fax)

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