An empirical investigation of idiosyncratic risk and stock returns relation in heteroskedasticity corrected predictive models

This paper investigates stock returns behaviour as a function of lagged idiosyncratic risk in the Fama-French three-factor model using two approaches to estimating idiosyncratic risk. The application of ordinary least squares and quantile regression methods to heteroskedasticity corrected data in a panel structure reveals that the form of relationship does not change with the method of estimating idiosyncratic risk and is indeed dynamic. The relationship curves resemble the shapes of the utility curves of risk-seeking and risk-aversion, and not the risk-neutral attitude. The findings are robust to the choice of FF three-factor and capital asset pricing one-factor models, and to the choice of estimation window. Our results help explain some of the basis of conflicting results reported in the literature on the form of idiosyncratic risk –return relation. The form of the relationship is too dynamic to support idiosyncratic risk as a ‘priced’ item.