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Idiosyncratic Risk Innovations and the Idiosyncratic Risk-ReturnRelation

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  • Mark Rachwalski
  • Quan Wen

Abstract

Stocks with increases in idiosyncratic risk tend to earn low subsequent returnsfor a few months. However, high idiosyncratic risk stocks eventually earnpersistently high returns. These results are consistent with positively pricedidiosyncratic risk and temporary underreaction to idiosyncratic riskinnovations. Because risk levels and innovations are correlated, the relationbetween historical idiosyncratic risk and returns may reflect both risk premiumsand underreaction and yield misleading inference regarding the price of risk.The results reconcile previous work offering conflicting evidence on the priceof idiosyncratic risk and help to discriminate among explanations for theidiosyncratic risk-return relation.

Suggested Citation

  • Mark Rachwalski & Quan Wen, 2016. "Idiosyncratic Risk Innovations and the Idiosyncratic Risk-ReturnRelation," The Review of Asset Pricing Studies, Society for Financial Studies, vol. 6(2), pages 303-328.
    • Handle: RePEc:oup:rasset:v:6:y:2016:i:2:p:303-328.
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    File URL: http://hdl.handle.net/10.1093/rapstu/raw002
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    Citations

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    Cited by:

    1. Sun, Kaisi & Wang, Hui & Zhu, Yifeng, 2022. "How is the change in left-tail risk priced in China?," Pacific-Basin Finance Journal, Elsevier, vol. 71(C).
    2. Han, Yufeng & Hu, Ou & Huang, Zhaodan, 2023. "A tale of idiosyncratic volatility and illiquidity shocks: Their correlation and effects on stock returns," International Review of Financial Analysis, Elsevier, vol. 86(C).
    3. Fenner, Richard G. & Han, Yufeng & Huang, Zhaodan, 2020. "Idiosyncratic volatility shocks, behavior bias, and cross-sectional stock returns," The Quarterly Review of Economics and Finance, Elsevier, vol. 75(C), pages 276-293.
    4. Yin, Libo & Yang, Zhichen, 2022. "The profitability effect: Insight from a dynamic perspective," International Review of Financial Analysis, Elsevier, vol. 80(C).
    5. Harris, Richard D.F. & Nguyen, Linh H. & Stoja, Evarist, 2019. "Systematic extreme downside risk," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 61(C), pages 128-142.
    6. Pi‐Hsia Hung & Donald Lien & Yun‐Ju Chien, 2020. "Portfolio concentration and fund manager performance," Review of Financial Economics, John Wiley & Sons, vol. 38(3), pages 423-451, July.
    7. Shahzad, Farrukh & Ahmad, Munir & Fareed, Zeeshan & Wang, Zhenkun, 2022. "Innovation decisions through firm life cycle: A new evidence from emerging markets," International Review of Economics & Finance, Elsevier, vol. 78(C), pages 51-67.
    8. Lars A. Lochstoer & Tyler Muir, 2022. "Volatility Expectations and Returns," Journal of Finance, American Finance Association, vol. 77(2), pages 1055-1096, April.

    More about this item

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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