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.
Idiosyncratic risk, Cross-sectional returns, Time varying
Finance and Financial Management | Portfolio and Security Analysis
Areas of Excellence
Finance and Financial Markets
Journal of Financial Economics
Idiosyncratic Risk and the Cross-Section of Expected Stock Returns. (2009). Journal of Financial Economics. 91, (1), 24-37. Research Collection Lee Kong Chian School Of Business.
Available at: http://ink.library.smu.edu.sg/lkcsb_research/3030