A New Test for the Detection of the Pricing Role of Aggregate Idiosyncratic Risk in the Predictive Regression

70 Pages Posted: 5 Oct 2013

See all articles by Tony Ruan

Tony Ruan

Xiamen University

Qian Sun

Fudan University

Yexiao Xu

University of Texas at Dallas - School of Management

Date Written: October 4, 2013

Abstract

The standard test for the pricing role of aggregate idiosyncratic risk in the conventional predictive regression considers aggregate total idiosyncratic risk a reasonable proxy for its undiversified component, which should be priced as theory suggests. However, when the priced component is relatively small, the test has little statistical power to reject the null hypothesis that idiosyncratic risk does not matter, even when the priced component, albeit small, explains an economically large portion of future excess return variation. We propose a simple regression-based method that can, under certain conditions, substantially improve the power of the test when economically important alternative hypotheses are true, but sacrifices little in the size of the test for the improved power. Based on the new test, we strongly reject the proposition that idiosyncratic risk does not matter and uncover a significantly positive relationship between aggregate undiversified idiosyncratic risk and future market excess returns.

Keywords: Dual predictors, expected return, idiosyncratic risk, predictability

Suggested Citation

Ruan, Tony and Sun, Qian and Xu, Yexiao, A New Test for the Detection of the Pricing Role of Aggregate Idiosyncratic Risk in the Predictive Regression (October 4, 2013). Available at SSRN: https://ssrn.com/abstract=2336015 or http://dx.doi.org/10.2139/ssrn.2336015

Tony Ruan (Contact Author)

Xiamen University ( email )

Xiamen, Fujian 361005
China

Qian Sun

Fudan University ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China
86 21 25011094 (Phone)

Yexiao Xu

University of Texas at Dallas - School of Management ( email )

P.O. Box 830688
Richardson, TX 75083-0688
United States
972-883-6703 (Phone)

HOME PAGE: http://www.utdallas.edu/~yexiaoxu

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