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No. 781: Pricing of Idiosyncratic Equity and Variance Risks

Elise Gourier , Queen Mary University of London

January 5, 2016

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Abstract

This paper decomposes the risk premia of individual stocks into contributions from systematic and idiosyncratic risks. I introduce an affine jump-diffusion model, which accounts for both the factor structure of asset returns and that of the variance of idiosyncratic returns. The estimation is performed on a time series of returns and option prices from 2006 to 2012. I find that investors not only require compensation for the systematic movements in returns and variance, but also for non hedgeable idiosyncratic risks. For the stocks of the Dow Jones, these risks account for an average of 50% and 80% of the equity and variance risk premia, respectively. I provide a categorization of sectors based on the risk profile of their Exchange Traded Funds and highlight the high prices of idiosyncratic risks in the Energy, Financial and Consumer Discretionary sectors. Other sectors are found to be appealing alternatives for investors who are not willing to be exposed to non diversifiable risks.

J.E.L classification codes: C38, C51, G12, G13

Keywords:Risk premia, Idiosyncratic risk

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