Idiosyncratic Risk Matters!

Authors

  • Amit Goyal,

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    • Santa-Clara is from the Anderson Graduate School of Management, University of California at Los Angeles; Goyal is from Goizueta Business School, Emory University. We thank Rob Arnott, Michael Brandt, Shingo Goto, Ludger Hentschel, Monika Piazzesi, Martin Schneider, Avanidhar Subrahmanyam, Walter Torous, and especially John Campbell, Richard Green (the editor), Richard Roll, Rossen Valkanov, and an anonymous referee for their comments and suggestions. We thank Kenneth French, Ľuboš Pàstor, G. William Schwert, and Avanidhar Subrahmanyam for generously providing data. We have benefited from the comments of seminar participants at the Berkeley Program in Finance, Chicago, Cornell, Emory, Harvard, Indiana, MIT, NBER Behavioral Finance Meeting, NYU, Ohio State, Rochester, UC Irvine, UCLA, U. Texas Austin, U. Washington, U. Western Ontario, and Yale. Any remaining errors are our own.

  • Pedro Santa-Clara

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    • Santa-Clara is from the Anderson Graduate School of Management, University of California at Los Angeles; Goyal is from Goizueta Business School, Emory University. We thank Rob Arnott, Michael Brandt, Shingo Goto, Ludger Hentschel, Monika Piazzesi, Martin Schneider, Avanidhar Subrahmanyam, Walter Torous, and especially John Campbell, Richard Green (the editor), Richard Roll, Rossen Valkanov, and an anonymous referee for their comments and suggestions. We thank Kenneth French, Ľuboš Pàstor, G. William Schwert, and Avanidhar Subrahmanyam for generously providing data. We have benefited from the comments of seminar participants at the Berkeley Program in Finance, Chicago, Cornell, Emory, Harvard, Indiana, MIT, NBER Behavioral Finance Meeting, NYU, Ohio State, Rochester, UC Irvine, UCLA, U. Texas Austin, U. Washington, U. Western Ontario, and Yale. Any remaining errors are our own.


Abstract

This paper takes a new look at the predictability of stock market returns with risk measures. We find a significant positive relation between average stock variance (largely idiosyncratic) and the return on the market. In contrast, the variance of the market has no forecasting power for the market return. These relations persist after we control for macroeconomic variables known to forecast the stock market. The evidence is consistent with models of time-varying risk premia based on background risk and investor heterogeneity. Alternatively, our findings can be justified by the option value of equity in the capital structure of the firms.

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