The Idiosyncratic Financial Factor: An Explanation for the Role of Size Factors and the Weak Intertemporal Risk-Return Relation

108 Pages Posted: 30 Apr 2019 Last revised: 3 Dec 2024

See all articles by Sung Je Byun

Sung Je Byun

Federal Reserve Bank of Dallas - Banking Supervision

Johnathan Loudis

University of Notre Dame - Mendoza College of Business

Lawrence Schmidt

MIT Sloan School of Management

Date Written: November 15, 2024

Abstract

In addition to a priced, dominant market factor (DMF), the value-weighted stock market return contains an “idiosyncratic financial factor” (IFF) related to overweighting of large-cap stocks. The IFF carries no risk premium, is unrelated to macroeconomic factors and returns in other markets, and significantly impacts systematic risk estimates. Size factors separate exposures to the DMF from the IFF. Consistent with a model with nontraded assets, using the DMF as an alternative market factor resolves the size anomaly and obviates the need for size factors in multifactor models. Finally, the DMF generates a stronger intertemporal risk-return tradeoff.

Keywords: Idiosyncratic risk, Market factor, Size effect, Size factors, Intertemporal risk-return relation

JEL Classification: C15, C58, G12, G17

Suggested Citation

Byun, Sung Je and Loudis, Johnathan and Schmidt, Lawrence, The Idiosyncratic Financial Factor: An Explanation for the Role of Size Factors and the Weak Intertemporal Risk-Return Relation (November 15, 2024). Available at SSRN: https://ssrn.com/abstract=3362066 or http://dx.doi.org/10.2139/ssrn.3362066

Sung Je Byun

Federal Reserve Bank of Dallas - Banking Supervision ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5660 (Phone)

HOME PAGE: http://https://sites.google.com/site/sungjebyun/

Johnathan Loudis

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

Lawrence Schmidt (Contact Author)

MIT Sloan School of Management ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States

HOME PAGE: http://https://sites.google.com/site/lawrencedwschmidt/home

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