Idiosyncratic Risk and Security Returns∗

The traditional CAPM approach argues that only market risk should be incorporated into asset prices and command a risk premium. This result may not hold, however, if some investors can not hold the market portfolio. For example, if one group of investors fails to hold the market portfolio for exogenous reasons, the remaining investors will also be unable to hold the market portfolio. Therefore, idiosyncratic risk could also be priced to compensate rational investors for an inability to hold the market portfolio. A variation of the CAPM model is derived to capture this observation as well as to draw testable implications. Under both Fama and MacBeth (1973) and Fama and French (1992) testing frameworks, we find that idiosyncratic volatility is useful in explaining cross-sectional expected returns. We also discover that returns from constructed portfolios and equity mutual funds directly co-vary with idiosyncratic risk hedging portfolio returns. ∗We are grateful to Ravi Bansal, Ted Day, Campbell R. Harvey, David Hirshleifer, Ravi Jagannathan, Grant McQueen, Larry Merville, Michael Pinegar, and Steven Thorley, seminar participants at the 2001 Annual Meeting of American Finance Association, 1999 Econometrics Society Conference, University Kansas, and Brigham Young University for helpful comments. We acknowledge with thanks the support of Princeton’s Bendheim Center for Finance and the Center for Policy Studies. The corresponding author’s address is: School of Management; The University of Texas at Dallas; Richardson, TX 75083. Telephone (972)883-6703; FAX (972)883-6522.