Is Idiosyncratic Risk Conditionally Priced?

37 Pages Posted: 10 Feb 2016 Last revised: 24 Apr 2019

See all articles by Rajnish Mehra

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics; National Bureau of Economic Research (NBER)

Sunil Wahal

Arizona State University (ASU) - Finance Department

Daruo Xie

Australian National University (ANU)

Multiple version iconThere are 2 versions of this paper

Date Written: April 22, 2019

Abstract

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify his model to allow the degree of diversification to vary with average idiosyncratic volatility. This simple recognition results in a state-dependent idiosyncratic risk premium that is higher when average idiosyncratic volatility is low, and vice versa. The data appear to be consistent with a positive state-dependent premium for idiosyncratic risk both in the US and in other developed markets.

Keywords: Incomplete markets, Diversification, Idiosyncratic risk

JEL Classification: G11, G12

Suggested Citation

Mehra, Rajnish and Wahal, Sunil and Xie, Daruo, Is Idiosyncratic Risk Conditionally Priced? (April 22, 2019). Available at SSRN: https://ssrn.com/abstract=2729433 or http://dx.doi.org/10.2139/ssrn.2729433

Rajnish Mehra

Arizona State University (ASU) - W.P Carey School of Business, Department of Economics ( email )

Tempe, AZ 85287-3806
United States
480 965 6335 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Sunil Wahal (Contact Author)

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

Daruo Xie

Australian National University (ANU) ( email )

Canberra, Australian Capital Territory 2601
Australia

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