Working Paper: NBER ID: w22016
Authors: Rajnish Mehra; Sunil Wahal; Daruo Xie
Abstract: 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.
Keywords: Idiosyncratic Risk; Asset Pricing; Diversification; Incomplete Markets
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| idiosyncratic risk (D81) | risk premium (G19) |
| average idiosyncratic volatility (C46) | risk premium (G19) |
| average idiosyncratic volatility is low (C46) | risk premium increases (G19) |
| average idiosyncratic volatility is high (C46) | risk premium decreases (G19) |
| idiosyncratic volatility (G19) | expected idiosyncratic volatility (C58) |
| diversification (G11) | marginal benefit from diversification (G11) |