Publication Type

Journal Article

Version

Preprint

Publication Date

1-2009

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

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Areas of Excellence

Finance and Financial Markets

Publication

Journal of Financial Economics

Volume

91

Issue

1

First Page

24

Last Page

37

ISSN

0304-405X

Identifier

10.1016/j.jfineco.2008.02.003

Publisher

Elsevier

Additional URL

http://dx.doi.org/10.1016/j.jfineco.2008.02.003

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