Idiosyncratic Jump Risk Matters: Evidence from Equity Returns and Options
142 Pages Posted: 2 Jun 2016 Last revised: 23 Sep 2018
Date Written: September 12, 2018
The recent literature provides conflicting empirical evidence on the pricing of idiosyncratic risk. This paper sheds new light on the matter by exploiting the richness of option data. First, we find that idiosyncratic risk explains 28% of the variation in the risk premium on a stock. Second, we show that the contribution of idiosyncratic risk to the equity premium arises exclusively from jump risk. Finally, we document that the commonality in idiosyncratic tail risk is much stronger than that in total idiosyncratic risk documented in the literature. Tail risk thus plays a central role in the pricing of idiosyncratic risk.
Keywords: Risk premiums; Idiosyncratic risk; Systematic risk; Tail risk; Option valuation; GARCH
JEL Classification: G12, G13
Suggested Citation: Suggested Citation