Idiosyncratic Risk Matters!

Amit Goyal · Pedro Santa-clara B

1,171 citations0/0 files storedThe Journal of Finance

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Financial Markets and Investment Strategies Financial Risk and Volatility Modeling Market Dynamics and Volatility

Abstract

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.

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References

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