Is Idiosyncratic Risk Conditionally Priced?

Rajnish Mehra; Sunil Wahal; Daruo Xie

doi:10.3386/w22016

Is Idiosyncratic Risk Conditionally Priced?

Rajnish Mehra, Sunil Wahal & Daruo Xie

Working Paper 22016

DOI 10.3386/w22016

Issue Date February 2016

Revision Date April 2019

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 with a positive state-dependent premium for idiosyncratic risk both in the US and in other developed markets.

This paper has circulated under the title “The Demand for Diversification in Incomplete Markets”. We thank Kerry Back, Jennifer Conrad, George Constantinides, Kevin Crotty, John Donaldson, Alex Horenstein, Pedram Jahangiry, Robert Merton, Kalle Rinne, Manuel Santos, Yuhang Xing, and the seminar participants at Aalto University, Miami University, Rice University, Vienna University and the WU Gutmann Center for helpful comments. The usual caveat applies. Wahal is a consultant to Dimensional Fund Advisors. DFA provided no funding or data for this research. he views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
MARC RIS BibTeΧ
- February 25, 2016
- April 7, 2017

Is Idiosyncratic Risk Conditionally Priced?

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