Abstract
In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify his 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. The data appear to be consistent a positive state-dependent premium for idiosyncratic risk both in the US and other developed markets.
| Original language | English |
|---|---|
| Pages (from-to) | 625-646 |
| Number of pages | 22 |
| Journal | Quantitative Economics |
| Volume | 12 |
| Issue number | 2 |
| DOIs | |
| Publication status | Published - May 2021 |