Open AccessIs idiosyncratic risk conditionally priced?
Author(s) -
Mehra Rajnish,
Wahal Sunil,
Xie Daruo
Publication year - 2021
Publication title -
quantitative economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 4.062
H-Index - 27
eISSN - 1759-7331
pISSN - 1759-7323
DOI - 10.3982/qe1528
Subject(s) - diversification (marketing strategy) , systematic risk , volatility (finance) , economics , incomplete markets , risk premium , econometrics , capital asset pricing model , financial economics , monetary economics , business , microeconomics , marketing
In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify his model to allow the degree of diversification to vary with average idiosyncratic volatility. This simple recognition results in a state‐dependent idiosyncratic risk premium that is higher when average idiosyncratic volatility is low, and vice versa. The data appear to be consistent a positive state‐dependent premium for idiosyncratic risk both in the US and other developed markets.