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Idiosyncratic risk and the cross-section of expected stock returns

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  • Fu, Fangjian
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    Abstract

    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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 91 (2009)
    Issue (Month): 1 (January)
    Pages: 24-37

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    Handle: RePEc:eee:jfinec:v:91:y:2009:i:1:p:24-37

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    Web page: http://www.elsevier.com/locate/inca/505576

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    Keywords: Idiosyncratic risk Cross-sectional returns Time-varying GARCH;

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