Date of Award
Master of Science (MS)
Economics and Finance
The trade-off between risk and return is a fundamental principle in finance. In any finance class, one will likely hear the phrase, “the greater the risk, the greater the return.” The Capital Asset Pricing Model (CAPM), one of the most basic and well-known finance models, estimates the expected return of an asset assuming a positive relation between expected return and a single risk factor. Empirically, risk control variables such as the CAPM beta along with other risk factors associated with market cap, book-to-market ratio, and illiquidity are used when pricing assets. Finance is abundant in theories all supporting positive risk-return relationships. In spite of the general, intuitive risk-return relationship, several studies have empirically observed risk factors, including idiosyncratic volatility, to be negatively related to the future return on a stock (Ang, Hodrick, Xing, and Zhang (2006)). This counterintuitive relationship invokes the question why a risk variable such as idiosyncratic volatility would have a negative effect on expected returns when theory suggests that risk should have a positive relationship with expected return.
Cannon, Brad, "The Idiosyncratic Volatility Puzzle: A Behavioral Explanation" (2015). All Graduate Plan B and other Reports. 466.
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