Idiosyncratic Risk Matters

Idiosyncratic Risk Matters
Author(s): Goyal, Amit and Welch, Ivo
Year: 2002
Paper Number: GBS-FIN-2002-001
Goizueta Department: Business - Finance

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.