Is idiosyncratic risk conditionally priced?

Rajnish Mehra, Sunil Wahal and Daruo Xie

Quantitative Economics, 2021, vol. 12, issue 2, 625-646

Abstract: 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.

Date: 2021
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https://doi.org/10.3982/QE1528

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Working Paper: Is Idiosyncratic Risk Conditionally Priced? (2016)
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