NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Daruo Xie

Australian National University
College of Business and Economics
Canberra, Australia
Australia

E-Mail: daruo.xie@anu.edu.au
Institutional Affiliation: Australian National University

NBER Working Papers and Publications

February 2016Is 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.
 
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