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This paper models the idiosyncratic or asset-specific return of an asset as the return on a portfolio that is long in that asset and short in other assets in the same class, thereby removing the common components of returns. This is the type of “hedged” position that is held by relative-value investors. Weekly returns data for seven different asset classes suggest that idiosyncratic risk is: higher at times of large return outcomes for the asset class as a whole; positively autocorrelated; and correlated across different asset classes. The implications for risk management are discussed.
Despite the debate on the pricing of idiosyncratic risk, it is generally believed that the pricing effect is likely to exist among small stocks due to lack of diversification and information asymmetry predicted by Merton (1987). However, given the size of Asset Under Management, most institutional investors focus on large stocks and hold portfolios different from that of the market portfolio in order to attract investors and to differentiate themselves. Moreover, large stocks will have a larger impact on the performance of a portfolio than small stocks, and institutional investors are more likely to be questioned when large stocks perform poorly. These unique features can forced institutional investors to care about idiosyncratic risk of larger stocks more than that of small stocks in their portfolio. Recognizing this important difference on the impact of idiosyncratic risk, we take an unorthodox approach by focusing on the effect of idiosyncratic risk within different groups of stocks. As a result, we find that large stocks' idiosyncratic volatilities indeed are positively related to their future stock returns, while small stocks idiosyncratic volatilities are negatively related to their future returns as documented. This finding also allows us to reconcile the inconsistent findings on the pricing of idiosyncratic risk in the current literature.
In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify this 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. We conduct a series of empirical tests to assess the presence and magnitude of the premium. In the US, in periods when average idiosyncratic volatility is low, the premium is significant and positive in both small and large capitalization stocks. We observe similar premia in markets outside the US.
Systemic risk remains a major concern to policymakers since widespread defaults in the corporate and financial sectors could pose substantial costs to society. Forward-looking measures and/or indicators of systemic default risk are thus needed to identify potential buildups of vulnerability in advance. In this paper, we explain how to construct idiosyncratic and systemic default risk indicators using the information embedded in single-tranche standardized collateralized debt obligations (STCDOs) referencing credit derivatives indices. As an illustration, both risk indicators are constructed for the European corporate sector using midprice quotes for STCDOs referencing the iTraxx Europe index.
In this study, the properties and portfolio management implications of the value- weighted idiosyncratic volatility in 24 emerging markets are examined. The paper provides evidence against the view that the rise of idiosyncratic risk is a global phenomenon. Furthermore, specific and market risks jointly predict market returns as there is a negative (positive) relation between idiosyncratic (market) risk and subsequent stock returns. Idiosyncratic volatility is the most important component of tracking error volatility and it does not exhibit either an upward or a downward trend. Thus, investors do not have to increase, on an average, the number of stocks that they hold, to keep the active risk constant.