Pricing of Idiosyncratic Risk in the Nordics

Abstract: We examine the Nordic equity markets during 1992-2011 for the pricing of idiosyncratic risk relative to the CAPM and the Fama-French three factor model. Classical financial theory predicts irrelevance of idiosyncratic volatility (IVOL) for expected returns, while contending theories of undiversified investors and theories from the field of behavioural finance predict a positive relationship. Recent empirical findings from international equity markets however indicate a negative relationship and our analysis support these findings. We find that a zero cost portfolio long in stocks with low IVOL and short stocks with high IVOL earns a positive and statistically significant alpha versus the FF-3 factor model of 1.14 per cent per month, implying a negative return towards holding idiosyncratic risk. Contrary to other low-volatility investment strategies, our results indicate that the low IVOL strategy is negatively related to the value premium. In addition, a positive relationship between IVOL and market beta is identified and evaluated.