Can Asset Pricing Models Price Idiosyncratic Risk in U.K. Stock Returns?

Authors


  • The author is grateful for helpful comments from two anonymous reviewers and Cynthia J. Campbell (Editor).

* Corresponding author: Department of Accounting and Finance, University of Strathclyde, Curran Building, 100 Cathedral Street, Glasgow, G4 0LN, United Kingdom; Phone: +44 (0) 141 548 3892; Fax: +44 (0) 141 552 3547; E-mail: j.fletcher@strath.ac.uk

Abstract

I examine how well different linear factor models and consumption-based asset pricing models price idiosyncratic risk in U.K. stock returns. Correctly pricing idiosyncratic risk is a significant challenge for many of the models I consider. For some consumption-based models, there is a clear tradeoff in the performance of the models between correctly pricing systematic risk and idiosyncratic risk. Linear factor models do a better job in most cases in pricing systematic risk than consumption-based models but the reverse is true for idiosyncratic risk.

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