The study presented in the following, sets out to investigate the effect of idiosyncratic risk on expected returns. In traditional financial literature, risk and return are positively related to each other. If theory holds, greater risk results in higher expected returns. Furthermore, the CAPM states that only systematic risk matters, while unsystematic (=idiosyncratic) risk can be diversified away. However, several studies identified that investors do not always hold fully diversified portfolios and, therefore, systematic risk is not necessarily the only risk factor to be considered.
In fact, in markets where not every investor is able to hold the market portfolio, investors might as well require a premium for bearing idiosyncratic risk. Previous empirical evidence on the relation between idiosyncratic risk and expected returns is diverse. While many researchers find a significant positive relation, others do not find any or even a significant negative relation.
Shedding light on the darkness with a meta-analysis.
Although the literature provides a large number of empirical studies on idiosyncratic volatility, a comprehensive overview is still missing. The study “A Review of the Cross-Section of Volatility and Expected Returns” by Dr. Sebastian Seidens helps to reconcile the conflicting empirical evidence by investigating different proxies of idiosyncratic risk, both from an empirical and a meta-perspective. Furthermore, the meta-analysis investigates the differences in the reported coefficients and a set of study-specific parameters that may be able to explain the conflicting empirical findings.