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

122 Pages Posted: 30 Apr 2019 Last revised: 29 Jan 2023

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: January 27, 2023

Abstract

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

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

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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