Journal
JOURNAL OF FINANCIAL ECONOMICS
Volume 91, Issue 1, Pages 24-37Publisher
ELSEVIER SCIENCE SA
DOI: 10.1016/j.jfineco.2008.02.003
Keywords
Idiosyncratic risk; Cross-sectional returns; Time-varying; GARCH
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Theories such as Merton [1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance 42, 483-510] predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang [2006. The cross-section of volatility and expected returns. 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. (C) 2008 Elsevier B.V. All rights reserved.
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