Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
45 Pages Posted: 8 Jul 2005 Last revised: 13 Nov 2013
Date Written: January 2009
Theories such as Merton (1987, Journal of Finance) predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang (2006, Journal of Finance 61, 259-299) however find that monthly stock returns are negatively related to the one-month lagged idiosyncratic volatilities. I show that idiosyncratic volatilities are time-varying and thus their findings should not be used to imply the relation between idiosyncratic risk and expected return. Using the exponential GARCH models to estimate expected idiosyncratic volatilities, I find a significantly positive relation between the estimated conditional idiosyncratic volatilities and expected returns. Further evidence suggests that Ang et al.'s findings are largely explained by the return reversal of a subset of small stocks with high idiosyncratic volatilities.
Keywords: Idiosyncratic risk, Cross-sectional returns, Time varying
JEL Classification: G11, G12, C52
Suggested Citation: Suggested Citation