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Idiosyncratic Risk Matters!
Author(s) -
Goyal Amit,
SantaClara Pedro
Publication year - 2003
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/1540-6261.00555
Subject(s) - economics , predictability , systematic risk , security market line , stock market , econometrics , financial economics , risk premium , equity (law) , market risk , stock (firearms) , expected return , portfolio , mechanical engineering , paleontology , physics , horse , quantum mechanics , political science , law , biology , engineering
This paper takes a new look at the predictability of stock market returns with risk measures. We find a significant positive relation between average stock variance (largely idiosyncratic) and the return on the market. In contrast, the variance of the market has no forecasting power for the market return. These relations persist after we control for macroeconomic variables known to forecast the stock market. The evidence is consistent with models of time‐varying risk premia based on background risk and investor heterogeneity. Alternatively, our findings can be justified by the option value of equity in the capital structure of the firms.