The central theme of this dissertation is the connection between idiosyncratic risk and returns. In the original literature perfect diversification assumptions eliminate the influence that idiosyncratic risk may have on returns; however, current research shows that once these restrictive assumptions are relaxed, a theoretical role for this particular risk reemerges. The current dissertation empirically investigates the role of idiosyncratic risk in explaining returns. Specifically, the work is organized into two main parts: the first investigates the connection between idiosyncratic risk and momentum, and the second examines the cross-sectional relation between returns and idiosyncratic risk.
The core idea of the first part of this dissertation is that, counter to common belief, the link between idiosyncratic risk and momentum should not be regarded as evidence of the irrational nature of the momentum phenomenon. If idiosyncratic risk is priced, time variation in its premia may rationally generate time series phenomena like momentum.
Various studies reject the notion that momentum profits are compensation for risk by showing that momentum profits are mostly comprised of idiosyncratic components. This dissertation starts with a few remarks on the current stage of the literature, which help make the point that simply documenting the existence of this connection can say nothing about the nature of the underlying process generating momentum (especially since recent theoretical papers show that idiosyncratic components of returns – in particular idiosyncratic risk – may affect risk premia). Using EGARCH-M, the first essay estimates idiosyncratic risk and idiosyncratic risk premia at the individual security level and shows that idiosyncratic risk premia are responsible for between 70 and 90 percent of momentum profits. Although securities in the loser portfolio have higher levels of idiosyncratic risk than those in the winner portfolio, the idiosyncratic risk premia in the loser portfolio are significantly smaller than those in the winner portfolio. Momentum portfolios formed by sorting on past idiosyncratic risk premia (rather than raw returns) generate significantly positive profits. Overall, the results provide strong empirical evidence that idiosyncratic risk premia vary cross-sectionally in a manner that rationally accounts for (at least portion of) momentum profits.
The next part of this dissertation investigates the cross-sectional relation between idiosyncratic risk and returns. Specifically, the second essay examines the validity of the incomplete information equilibrium model advanced by Merton (1987), by investigating one particular implication that has been largely ignored in previous literature: the interaction between the visibility of a stock and the pricing of its idiosyncratic risk. Four different proxies for visibility provide convincing evidence that idiosyncratic risk premia are larger for neglected stocks, and smaller or even economically insignificant for visible stocks. Results also corroborate Merton's hypothesis that the size effect previously documented in the literature is likely to be the result of an omitted variable (idiosyncratic risk). The evidence provides support to the idea that market segmentation generated by incomplete information is strong enough to be at least partly responsible for the documented role of idiosyncratic risk in the cross-section of returns.