Is Idiosyncratic Risk Conditionally Priced?
37 Pages Posted: 1 Mar 2016 Last revised: 27 Feb 2021
Date Written: February 2016
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.
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