Expected Equity Returns Should Correlate with Idiosyncratic Risk

50 Pages Posted: 25 Oct 2018

See all articles by Giovanni Bruno

Giovanni Bruno

EDHEC Business School - Scientific Beta

Jørgen Haug

Norwegian School of Economics (NHH) - Department of Finance

Date Written: October 3, 2018

Abstract

Because levered equity is an option on the firm, variations in asset idiosyncratic risk (ivol) induces a negative relationship between equity ivol and expected returns. We show that the effect is caused by the nonlinear payoff of equity and the law of one price, and is present in all but risk-neutral economies. We test the cross-sectional predictions of our theory by contrasting the ivol-return relationship at the equity and asset levels. The ivol-return relationship is stronger for equity than for assets, and stronger for more levered firms — consistent with the theory. We test also the timeseries implications of the theory. Time variation in asset ivol causes time variation in the option value of equity that translates into time varying risk factor loadings. Unconditional alpha subsequently becomes biased when asset ivol correlates with the market price of risk. We show empirically that a conditional CAPM that accounts for time variation in equity nonlinearity helps explain earlier findings that high-minuslow ivol-portfolios generate negative unconditional alpha.

Keywords: asset volatility, conditional CAPM, coskewness, covariance, equity elasticity, expected returns, idiosyncratic risk puzzle, leverage effect

JEL Classification: G11, G12, G13, G32

Suggested Citation

Bruno, Giovanni and Haug, Jørgen, Expected Equity Returns Should Correlate with Idiosyncratic Risk (October 3, 2018). Available at SSRN: https://ssrn.com/abstract=3260448 or http://dx.doi.org/10.2139/ssrn.3260448

Giovanni Bruno

EDHEC Business School - Scientific Beta ( email )

393 Prom. des Anglais
Nice, PACA 06200
France

Jørgen Haug (Contact Author)

Norwegian School of Economics (NHH) - Department of Finance ( email )

Helleveien 30
N-5045 Bergen
Norway

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