Idiosyncratic financial risk and a reevaluation of the market risk-return tradeoff
122 Pages Posted: 30 Apr 2019 Last revised: 29 Jan 2023
Date Written: January 27, 2023
In addition to a dominant level factor, stock market index returns contain an “idiosyncratic financial factor” (IFF) unrelated to macroeconomic aggregates. We argue the IFF contaminates tests of the risk-return tradeoff in the time series and cross section, then we reevaluate these tests using an alternative index unaffected by the IFF. Our index generates a stronger relation between its risk premium and conditional variance. It also generates larger cross-sectional variation in market betas, and these exposures explain more variation in expected returns. Our index prices size portfolios and eliminates the pricing power of size factors across many standard factor models.
Keywords: Risk-Return Trade-Off; Idiosyncratic Risk; Empirical Asset Pricing
JEL Classification: C15, C58, G12, G17
Suggested Citation: Suggested Citation