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

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Cotter, John
O'Sullivan, Niall
Rossi, Francesco
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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.
Asset pricing , Idiosyncratic risk , Turnover , Conditional beta
Cotter, J., O'Sullivan, N. & Rossi, F., The Conditional Pricing of Systematic and Idiosyncratic Risk in the UK Equity Market, International Review of Financial Analysis (2014), doi: 10.1016/j.irfa.2014.10.002 [In Press]
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Copyright © 2014 Published by Elsevier Inc. NOTICE: this is the author’s version of a work that was accepted for publication in International Review of Financial Analysis. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in International Review of Financial Analysis [In Press] DOI: 10.1016/j.irfa.2014.10.002