Daruo Xie, W.P. Carey School of Business, Arizona State University
Merton (1987) predicts that idiosyncratic risk can be priced. I develop a simple equilibrium model of capital markets with information costs in which the idiosyncratic risk premium depends on the average level of idiosyncratic volatility. This dependence suggests that idiosyncratic risk premium varies over time. I find that in US markets, the covariance between stock-level idiosyncratic volatility and the idiosyncratic risk premium explains future cross-sectional stock returns. Stocks in the highest quintile of the covariance between the volatility and risk premium earn average 3-factor alpha of 70 bps per month higher than those in the lowest quintile.