Idiosyncratic financial risk and a reevaluation of the market risk-return tradeoff

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

Byun, Sung Je and Loudis, Johnathan and Schmidt, Lawrence, Idiosyncratic financial risk and a reevaluation of the market risk-return tradeoff (January 27, 2023). Available at SSRN: https://ssrn.com/abstract=3362066 or http://dx.doi.org/10.2139/ssrn.3362066