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Does idiosyncratic risk matter: another look

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  • Hui Guo
  • Robert Savickas
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Abstract

We show that the equal-weighted average stock volatility analyzed by Goyal and Santa-Clara (GS, 2003) forecasts stock returns because of its co-movements with stock market volatility. Moreover, contrary to the positive relation hypothesized by GS and many others, we find that the value-weighted average stock volatility is negatively related to future stock returns when combined with stock market volatility. This puzzling result reflects the fact that the alue-weighted average stock volatility is negatively correlated with the consumption-wealth ratio, and its predictive power vanishes if we control for the latter in the forecasting equation. The idiosyncratic volatility proposed by GS thus provides no information beyond the forecasting variables advocated by Guo (2003)2:26 PM 10/17/03

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2003-025.

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Date of creation: 2003
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Handle: RePEc:fip:fedlwp:2003-025

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Keywords: Stock market ; Asset pricing;

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  1. John Y. Campbell & Martin Lettau & Burton G. Malkiel & Yexiao Xu, 2000. "Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk," NBER Working Papers 7590, National Bureau of Economic Research, Inc.
  2. Eric Ghysels & Pedro Santa-Clara & Rossen Valkanov, 2004. "There is a Risk-Return Tradeoff After All," CIRANO Working Papers 2004s-24, CIRANO.
  3. John T. Scruggs, 1998. "Resolving the Puzzling Intertemporal Relation between the Market Risk Premium and Conditional Market Variance: A Two-Factor Approach," Journal of Finance, American Finance Association, vol. 53(2), pages 575-603, 04.
  4. Andrew Ang & Robert J. Hodrick & Yuhang Xing & Xiaoyan Zhang, 2006. "The Cross-Section of Volatility and Expected Returns," Journal of Finance, American Finance Association, vol. 61(1), pages 259-299, 02.
  5. Merton, Robert C., 1987. "A simple model of capital market equilibrium with incomplete information," Working papers 1869-87., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  6. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  7. Levy, Haim, 1978. "Equilibrium in an Imperfect Market: A Constraint on the Number of Securities in the Portfolio," American Economic Review, American Economic Association, vol. 68(4), pages 643-58, September.
  8. Brad M. Barber & Terrance Odean, 2000. "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," Journal of Finance, American Finance Association, vol. 55(2), pages 773-806, 04.
  9. Amit Goyal & Pedro Santa-Clara, 2003. "Idiosyncratic Risk Matters!," Journal of Finance, American Finance Association, vol. 58(3), pages 975-1008, 06.
  10. Bruce N. Lehmann, 1986. "Residual Risk Revisited," NBER Working Papers 1908, National Bureau of Economic Research, Inc.
  11. Lehmann, Bruce N., 1990. "Residual risk revisited," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 71-97.
  12. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
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