Is Idiosyncratic Risk Conditionally Priced?
37 Pages Posted: 10 Feb 2016 Last revised: 24 Apr 2019
Date Written: April 22, 2019
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: Suggested Citation