Idiosyncratic Risk and the Cross-Section of Expected Stock Returns

Theories such as Merton (1987, Journal of Finance) predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang (2006, Journal of Finance 61, 259-299) however find that monthly stock returns are negatively r...

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Main Author: FU, Fangjian
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Language:English
Published: Institutional Knowledge at Singapore Management University 2006
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Online Access:https://ink.library.smu.edu.sg/lkcsb_research/1425
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spelling sg-smu-ink.lkcsb_research-24242010-09-23T06:24:04Z Idiosyncratic Risk and the Cross-Section of Expected Stock Returns FU, Fangjian Theories such as Merton (1987, Journal of Finance) predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang (2006, 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. 2006-01-01T08:00:00Z text https://ink.library.smu.edu.sg/lkcsb_research/1425 Research Collection Lee Kong Chian School Of Business eng Institutional Knowledge at Singapore Management University Idiosyncratic risk Cross-sectional returns Time varying Business
institution Singapore Management University
building SMU Libraries
continent Asia
country Singapore
Singapore
content_provider SMU Libraries
collection InK@SMU
language English
topic Idiosyncratic risk
Cross-sectional returns
Time varying
Business
spellingShingle Idiosyncratic risk
Cross-sectional returns
Time varying
Business
FU, Fangjian
Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
description Theories such as Merton (1987, Journal of Finance) predict a positive relation between idiosyncratic risk and expected return when investors do not diversify their portfolio. Ang, Hodrick, Xing, and Zhang (2006, 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.
format text
author FU, Fangjian
author_facet FU, Fangjian
author_sort FU, Fangjian
title Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
title_short Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
title_full Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
title_fullStr Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
title_full_unstemmed Idiosyncratic Risk and the Cross-Section of Expected Stock Returns
title_sort idiosyncratic risk and the cross-section of expected stock returns
publisher Institutional Knowledge at Singapore Management University
publishDate 2006
url https://ink.library.smu.edu.sg/lkcsb_research/1425
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