The conditional pricing of systematic and idiosyncratic risk in the UK equity market

Abstract

We test whether firm idiosyncratic risk is priced in a large cross-section of U.K. stocks. A distinguishing feature of our paper is that our tests allow for a conditional relationship between systematic risk (beta) and returns, i.e., conditional on whether the excess market return is positive or negative. We find strong evidence in support of a conditional beta/return relationship which in turn reveals conditionality in the pricing of idiosyncratic risk. We find that idiosyncratic volatility is significantly negatively priced in stock returns in down-markets. Although perhaps initially counter-intuitive, we describe the theoretical support for such a finding in the literature. Our results also reveal some role for liquidity, size and momentum risk but not value risk in explaining the cross-section of returns.