Quantitative Economics: May, 2021, Volume 12, Issue 2

Is idiosyncratic risk conditionally priced?

Rajnish Mehra, Sunil Wahal, Daruo Xie

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 a positive state‐dependent premium for idiosyncratic risk both in the US and other developed markets.

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