Is Idiosyncratic Risk Quantitatively Significant

In Merton (1987), idiosyncratic risk is priced in equilibrium as a consequence of incomplete diversification. We modify this 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. We conduct a series of empirical tests to assess the presence and magnitude of the premium. In the US, in periods when average idiosyncratic volatility is low, the premium is significant and positive in both small and large capitalization stocks. We observe similar premia in markets outside the US.