Idiosyncratic Risk Innovations and the Idiosyncratic Risk-Return Relation

Abstract

Stocks with increases in idiosyncratic risk tend to earn low subsequent returns for a few months. However, high idiosyncratic risk stocks eventually earn persistently high returns. These results are consistent with positively priced idiosyncratic risk and temporary underreaction to idiosyncratic risk innovations. Because risk levels and innovations are correlated, the relation between historical idiosyncratic risk and returns may reect both risk premia and underreaction and yield misleading inference regarding the price of risk. The results reconcile previous work, which offers conflicting evidence on the price of idiosyncratic risk, and help to discriminate among explanations of the idiosyncratic risk-return relation.

Keywords: Idiosyncratic Volatility, Idiosyncratic Risk, Cross-section, Stock Returns, Underreaction, Frictions

JEL Classification: G12, G14