Two essays on the impact of idiosyncratic risk on asset returns

In this dissertation, I explore the impact of idiosyncratic risk on asset returns. The first essay examines how idiosyncratic risk affects the cross-section of stock returns. I use an exponential GARCH model to forecast expected idiosyncratic volatility and employ a combination of the size effect, value premium, return momentum and short-term reversal to measure relative mispricing. I find that stock returns monotonically increase in idiosyncratic risk for relatively undervalued stocks and monotonically decrease in idiosyncratic risk for relatively overvalued stocks. This phenomenon is robust to various subsamples and industries, and cannot be explained by risk factors or firm characteristics. Further, transaction costs, short-sale constraints and information uncertainty cannot account for the role of idiosyncratic risk. Overall, these findings are consistent with the limits of arbitrage arguments and demonstrate the importance of idiosyncratic risk as an arbitrage cost. The second essay studies the cross-sectional determinants of delta-hedged stock option returns with an emphasis on the pricing of volatility risk. We find that the average delta-hedged option returns are significantly negative for most stocks, and they decrease monotonically with both total and idiosyncratic volatility of the underlying stock. Our results are robust and cannot be explained by the Fama-French factors, market volatility risk, jump risk, or the effect of past stock return and volatility-related option mispricing. Our results strongly support a negative market price of volatility risk specification that is proportional to the volatility level. Reflecting this volatility risk premium, writing covered calls on high volatility stocks on average earns about 2% more per month than selling covered calls on low volatility stocks. This spread is higher when it is more difficult to arbitrage between stock and option.