Idiosyncratic Risk and the Cross-Section of Expected Stock Returns

45 Pages Posted: 8 Jul 2005 Last revised: 13 Nov 2013

See all articles by Fangjian Fu

Fangjian Fu

Singapore Management University - Lee Kong Chian School of Business

Date Written: January 2009

Abstract

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

Fu, Fangjian, Idiosyncratic Risk and the Cross-Section of Expected Stock Returns (January 2009). Journal of Financial Economics, Vol. 91, pp. 24-37, January 2009. Available at SSRN: https://ssrn.com/abstract=676828

Fangjian Fu (Contact Author)

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore, 178899
Singapore

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