Australian National University
College of Business and Economics
Institutional Affiliation: Australian National University
NBER Working Papers and Publications
|February 2016||Is Idiosyncratic Risk Conditionally Priced?|
with Rajnish Mehra, Sunil Wahal: w22016
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 with a positive state-dependent premium for idiosyncratic risk both in the US and in other developed markets.