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

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: 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